The Choice of a Monetary Policy Reaction Function in a Simple Optimizing Model

Finance Discussion Papers Number 601

Posted: 11 Mar 1998

Date Written: January 1998

Abstract

Monetary policy reaction functions are compared in a simple optimizing model with one-period nominal stickiness, i.i.d. shocks, and no capital accumulation. The interest rate is the instrument and is either kept constant, "interest rate targeting" for short, or used in targeting one of the following: money, the price level, output, nominal income (output), money growth, inflation, and the sum of inflation and output. There are three varieties of one-period nominal stickiness---wage stickiness, wage and price stickiness, and price stickiness---and three kinds of shocks---money demand shocks, goods demand shocks, and productivity shocks. A given type of targeting is "better" than some other type for a given variable and kind of shock if it results in smaller deviations of the variable from its target value. Some familiar results regarding the ranking of types of targeting are confirmed in the optimizing model, and some new results are obtained. It is not surprising that rankings may depend both on the type of shock and on which variable is the target variable. However, it may be somewhat surprising that, given that wages are sticky, rankings depend on whether prices are sticky, but that given that prices are sticky rankings do not depend on whether wages are sticky.

JEL Classification: E52

Suggested Citation

Henderson, Dale W. and Kim, Jinill, The Choice of a Monetary Policy Reaction Function in a Simple Optimizing Model (January 1998). Finance Discussion Papers Number 601, Available at SSRN: https://ssrn.com/abstract=65749

Dale W. Henderson (Contact Author)

Federal Reserve Board ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2343 (Phone)
202-736-5638 (Fax)

Jinill Kim

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701

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