Optimal State-dependent Monetary Policy Rules

Christian Baker and Richard Evans
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Christian Baker: Department of Economics, Brigham Young University

No 2013-04, BYU Macroeconomics and Computational Laboratory Working Paper Series from Brigham Young University, Department of Economics, BYU Macroeconomics and Computational Laboratory

Abstract: This paper defines a monetary equilibrium and computes an optimal nonlinear, full-information, state-dependent monetary policy rule to which the monetary authority commits at the beginning of time. This type of optimal monetary policy represents a combination of the flexibility of discretion with the time consistency of commitment. The economic environment is a closed-economy general equilibrium model of incomplete markets with monopolistic competition, producer price stickiness, and a transaction cost motive for holding money. We prove existence and uniqueness of the competitive equilibrium given a monetary policy rule and prove existence of the optimal rule. We show that the optimal state-dependent monetary policy rule satisfies the standard results of the discretionary policy literature in that it keeps inflation and nominal interest rates low (Friedman rule) and reduces inefficient variance in prices. Lastly, we compare the optimal monetary policy rule to a limited-information Taylor rule. We find that the Taylor rule, based on observable macroeconomic variables, is able to closely approximate the economic outcomes of the model under the optimal full-information rule.

Keywords: Optimal monetary policy; Money supply rules; Time consistency; Nonlinear solution methods (search for similar items in EconPapers)
JEL-codes: C68 E31 E42 E52 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2013-10
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:byu:byumcl:201304

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