Optimal Monetary Policy

51 Pages Posted: 20 Dec 2002 Last revised: 31 Oct 2010

See all articles by Aubhik Khan

Aubhik Khan

Ohio State University (OSU)

Robert G. King

Boston University - Department of Economics; Federal Reserve Bank of Richmond - Research Department; National Bureau of Economic Research (NBER)

Alexander L. Wolman

Federal Reserve Bank of Richmond

Multiple version iconThere are 3 versions of this paper

Date Written: December 2002

Abstract

Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two sets of frictions -- costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods -- we find optimal monetary policy is governed by two familiar principles. First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate. Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those which would occur if prices were flexible. In our benchmark model, there is some tendency for the monetary authority to smooth nominal and real interest rates.

Suggested Citation

Khan, Aubhik and King, Robert G. and Wolman, Alexander L., Optimal Monetary Policy (December 2002). NBER Working Paper No. w9402. Available at SSRN: https://ssrn.com/abstract=364746

Aubhik Khan

Ohio State University (OSU) ( email )

2120 Fyffe Road
Columbus, OH OH 43210
United States

Robert G. King (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-5941 (Phone)

Federal Reserve Bank of Richmond - Research Department

P.O. Box 27622
Richmond, VA 23261
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Alexander L. Wolman

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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