State Dependent Monetary Policy
34 Pages Posted: 2 Jun 2014
Date Written: January 2014
We study the optimal anticipated monetary policy in a flexible-price economy featuring heterogenous agents and incomplete markets, which give rise to a business cycle. In this setting money policy has distributional effects that depend on the state of the cycle. We parsimoniously characterize the dynamics of the economy and study the optimal regulation of the money supply as a function of the state. The optimal policy prescribes monetary expansions in recessions, when insurance is most needed by cash- poor unproductive agents. To minimize the inflationary effect of these expansions the policy prescribes monetary contractions in good times. Although the optimal money growth rate varies greatly through the business cycle, this policy echoes Friedmans principle in the sense that the expected real return of money approaches the rate of time preference.
Keywords: distributional effects, heterogenous agents, incomplete markets, liquidity, precautionary savings
JEL Classification: E50
Suggested Citation: Suggested Citation