Optimal Monetary Policy and the Correlation between Prices and Output

Contributions to Macroeconomics, Vol. 3, No. 1, 2003

Posted: 2 Jun 2003

See all articles by James Peery Cover

James Peery Cover

University of Alabama - Department of Economics, Finance and Legal Studies

Paul Pecorino

University of Alabama - Department of Economics, Finance and Legal Studies

Abstract

Several empirical papers have established the fact of a negative price-output correlation for the United States in the post WWII era. Much of this work appears to interpret the sign of this correlation under the assumption that monetary policy is passive. This paper uses a simple aggregate supply and demand model to examine how an optimizing monetary policy affects the price-output correlation. The model is capable of explaining why the price-output correlation in the United States is positive with prewar data but negative with postwar data. The model implies that a negative price-output correlation can emerge under an optimal policy only if policymakers are concerned with both inflation and output and the underlying economy is one in which both demand and supply shocks affect output. The model implies that a negative price-output correlation is inconsistent with real-business cycle models, while a positive correlation does not necessarily support the use of neo-Keynesian models.

Keywords: Optimal Monetary Policy, Price-output correlation

JEL Classification: E0

Suggested Citation

Cover, James Peery and Pecorino, Paul, Optimal Monetary Policy and the Correlation between Prices and Output. Contributions to Macroeconomics, Vol. 3, No. 1, 2003, Available at SSRN: https://ssrn.com/abstract=394641

James Peery Cover

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

P.O. Box 870244
Tuscaloosa, AL 35487
United States
205-348-8977 (Phone)
205-348-0590 (Fax)

Paul Pecorino (Contact Author)

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

P.O. Box 870244
Tuscaloosa, AL 35487
United States
205-348-0379 (Phone)
205-348-0590 (Fax)

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