Some Monetary Policy Implications of Increasing Consumption Variety
Federal Reserve Bank of Philadelphia Working Paper WP 95-28
Posted: 23 Sep 1996
Date Written: Undated
A simple monetary model with increasing consumption variety is used to examine issues surrounding optimal monetary policy and its implementation. When consumption variety is increasing, there is a wedge driven between inflation measured in terms of goods prices and inflation measured in terms of price indexes that capture the benefits to consumers of increasing variety. The optimal rate of inflation is a function of the parameters that govern changing variety. However, optimal monetary policy in the model gives the standard result of setting the short-term nominal interest rate to zero. Implementing the optimal monetary policy using a money growth rule appears to be complicated by the fact that the underlying state variables for the economy include the growth rates of consumption good variety. However, the monetary authority can implement the optimal policy by contracting the money stock at the real interest measured using goods prices, even though this rate is not the one that marginal rates of substitution are equated to at the optimum. The model thus suggests that an optimal monetary policy can be implemented using a Friedman rule even in an economy where prices are missmeasured. The views expressed in this paper are the author's and not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
JEL Classification: E52, E42
Suggested Citation: Suggested Citation