Implementation of Optimal Monetary Policy

21 Pages Posted: 8 Dec 2012

See all articles by Michael Dotsey

Michael Dotsey

Federal Reserve Bank of Philadelphia

Andreas Hornstein

Federal Reserve Bank of Richmond

Date Written: 2006

Abstract

Optimal monetary policy analysis can be viewed as a constrained optimization problem: the policymaker chooses a competitive equilibrium allocation that maximizes social welfare among the set of all feasible competitive equilibrium allocations. Part of the solution to this problem is a monetary policy rule that determines how variables that are under direct control of the policymaker -- the monetary policy instruments -- are set. An optimal policy rule is said to implement the optimal allocation if, conditional on the policy rule, the allocation is the unique rational expectations equilibrium of the economy. For a simple monetary model, we study the implementation of full-commitment and Markov-perfect policies when the policymaker uses a money-stock instrument. For a local approximation of the economy, we show that both policy rules implement the respective optimal allocations. We also show that the results for local approximations do not necessarily extend to a global analysis of the economy: the Markov-perfect policy rule is not implementable, and there is no proof that the full-commitment policy rule is implementable.

Suggested Citation

Dotsey, Michael and Hornstein, Andreas, Implementation of Optimal Monetary Policy (2006). FRB Richmond Economic Quarterly, vol. 92, no. 2, Spring 2006, pp. 113-133. Available at SSRN: https://ssrn.com/abstract=2186124

Michael Dotsey (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States
804-697-8201 (Phone)
804-697-8255 (Fax)

Andreas Hornstein

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States
804-697-8266 (Phone)
804-697-8255 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
18
Abstract Views
276
PlumX Metrics