Monetary Policy with State Contingent Interest Rates

Abstract

What instruments of monetary policy must be used in order to implement a unique equilibrium? This paper revisits the issues addressed by Sargent and Wallace (1975) on the multiplicity of equilibria when policy is conducted with interest rate rules. We show that the appropriate interest rate instruments under uncertainty are state-contingent interest rates, i.e. the nominal returns on state-contingent nominal assets. A policy that pegs state-contingent nominal interest rates, and sets the initial money supply, implements a unique equilibrium. These results hold whether prices are flexible or set in advance.

Keywords: Monetary policy, policy instruments, sticky prices, state-contingent interest rates

JEL Classification: E31, E40, E52, E58, E62, E63