Inflation Targeting and Nominal-Income-Growth Targeting: When and Why are They Suboptimal?
40 Pages Posted: 27 Feb 2005
We compare optimal and simple interest-rate rules. Our model features optimizing agents, monopolistic competition in both product and labor markets, and one-period nominal contracts (for wages alone or for both wages and prices) signed before shocks are known. Exact solutions insure that we obtain correct welfare conclusions. Optimal rules maximize the unconditional expected utility of the representative agent with commitment subject to the information set of the policymaker. Even with monopolistic distortions, the optimal full-information rule makes the economy mimic the hypothetical full-flexibility equilibrium. Strict versions of inflation targeting, nominal-income-growth targeting, and other such simple rules are suboptimal under both full and partial information but flexible versions are optimal under certain partial-information assumptions. Nominal-income-growth targeting dominates inflation targeting for plausible parameter values.
Keywords: optimal monetary policy, interest-rate rule, inflation targeting, nominal-income-growth targeting, wage and price contracts
JEL Classification: E52, E50, E31
Suggested Citation: Suggested Citation