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Optimal Monetary Policy Rules Under Persistent Shocks


  • Bhattacharya, Joydeep
  • Singh, Rajesh


The tug-o-war for supremacy between inflation targeting and monetary targeting is a classic yet timely topic in monetary economics. In this paper, we revisit this question within the context of a pure-exchange overlapping generations model of money where spatial separation and random relocation create an endogenous demand for money. We distinguish between shocks to real output and shocks to the real interest rate. Both shocks are assumed to follow AR(1) processes. Irrespective of the nature of shocks, the optimal inflation target is always positive. Under monetary targeting, shocks to endowment require negative money growth rates, while under shocks to real interest rates it may be either positive or negative depending on the elasticity of consumption substitution. Also, monetary targeting welfare-dominates inflation targeting but the gap between the two vanishes as the shock process approaches a random walk. In sharp contrast, for shocks to the real interest rate, we prove that monetary targeting and inflation targeting are welfare-equivalent only in the limit when the shocks become i.i.d.! The upshot is that persistence of the underlying fundamental uncertainty matters: depending on the nature of the shock, policy responses can either be more or less aggressive as persistence increases.

Suggested Citation

  • Bhattacharya, Joydeep & Singh, Rajesh, 2008. "Optimal Monetary Policy Rules Under Persistent Shocks," Staff General Research Papers Archive 12863, Iowa State University, Department of Economics.
  • Handle: RePEc:isu:genres:12863

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    References listed on IDEAS

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    Cited by:

    1. Kryvtsov, Oleksiy & Shukayev, Malik & Ueberfeldt, Alexander, 2011. "Optimal monetary policy under incomplete markets and aggregate uncertainty: A long-run perspective," Journal of Economic Dynamics and Control, Elsevier, vol. 35(7), pages 1045-1060, July.

    More about this item


    overlapping generations; random relocation model; monetary targeting; inflation targeting; real shocks; persistence;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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