Interest rate versus money supply instruments: on the implementation of Markov-perfect optimal monetary policy

Michael Dotsey and Andreas Hornstein

No 07-27, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: Currently there is a growing literature exploring the features of optimal monetary policy in New Keynesian models under both commitment and discretion. With respect to time consistent policy, the literature focuses on solving for allocations. Recently, however, King and Wolman (2004) have examined implementation issues involved under time consistent policy when the monetary authority chooses nominal money balances. Surprisingly, they find that equilibria are no longer unique under a money stock regime. Indeed, there exist multiple steady states. Dotsey and Hornstein find that King and Wolman's conclusion of non-uniqueness of Markov-perfect equilibria is sensitive to the instrument of choice. If, instead, the monetary authority chooses the nominal interest rate rather than nominal money balances, there exists a unique Markov-perfect steady state and point-in-time equilibria are unique as well. Thus, in King and Wolman's language, monetary policy is implementable using an interest rate instrument while it is not implementable using a money stock instrument.

Keywords: Markov processes; Monetary policy; Money supply (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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