Linear-Quadratic Approximation to Unconditionally Optimal Policy: The Distorted Steady-State
This paper establishes that one can generally obtain a purely quadratic approximation to the unconditional expectation of social welfare when the steady-state is distorted. A specific example is provided employing a canonical New Keynesian model. Unlike in the non-distorted steady state case, the approximate loss function is not defined simply over terms in inflation and output. Furthermore, optimal steady state inflation and the nominal interest rate are positive.
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