Optimal Monetary Policy and Correlation between Prices and Output

Abstract

Several authors have reported finding a negative correlation between prices and output for the U.S. in the post WW II data. This paper presents a simple aggregate supply and demand model to show that this correlation may reflect the actions of an optimizing monetary policy maker rather than the relative sizes of the aggregate demand and supply shocks which hit the economy. Because the optimizing policy maker seeks to offset fully the effects of aggregate demand shocks, when the policy maker views these shocks with greater precision, the observed correlation of prices and output falls and can become negative. Importantly, our model is consistent with the observed changed in the price-output correlation between the pre WW II and post WW II periods.

Keywords: optimal monetary policy, price-output correlation

JEL Classification: E3, E5