Inflation Risk and Optimal Monetary Policy
FRB of St. Louis Working Paper No. 2006-035C
30 Pages Posted: 23 May 2006
Date Written: December 2007
This paper shows that the optimal monetary policies recommended by New Keynesian models still imply a large amount of inflation risk. We calculate the term structure of inflation uncertainty in New Keynesian models when the monetary authority adopts the optimal policy. When the monetary policy rules are modified to include some weight on a price path, the economy achieves equilibria with substantially lower long-run inflation risk. With either sticky prices or sticky wages, a price path target reduces the variance of inflation by an order of magnitude more than it increases the variability of the output gap.
Keywords: Optimal Monetary Policy, Nominal Rigidities, Inflation Risk
JEL Classification: E31, E32, E42
Suggested Citation: Suggested Citation