Inflation Risk and Optimal Monetary Policy

FRB of St. Louis Working Paper No. 2006-035C

30 Pages Posted: 23 May 2006

See all articles by William T. Gavin

William T. Gavin

Federal Reserve Bank of St. Louis - Research Division; University of Memphis Department of Economics

Benjamin D. Keen

University of Oklahoma - Department of Economics

Michael R. Pakko

Arkansas Economic Development Institute

Date Written: December 2007

Abstract

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

Gavin, William T. and Keen, Benjamin D. and Pakko, Michael R., Inflation Risk and Optimal Monetary Policy (December 2007). FRB of St. Louis Working Paper No. 2006-035C, Available at SSRN: https://ssrn.com/abstract=903802 or http://dx.doi.org/10.2139/ssrn.903802

William T. Gavin (Contact Author)

Federal Reserve Bank of St. Louis - Research Division ( email )

441 Locust Street
P. O. Box 442
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314 873-8422 (Phone)

HOME PAGE: http://www.gavinecon.com

University of Memphis Department of Economics ( email )

Memphis, TN 38152
United States

Benjamin D. Keen

University of Oklahoma - Department of Economics ( email )

729 Elm Avenue
Norman, OK 73019-2103
United States

Michael R. Pakko

Arkansas Economic Development Institute ( email )

2801 South University Avenue
Little Rock, AR 72204
United States
501-569-8541 (Phone)
501-569-8538 (Fax)

HOME PAGE: http://https://ualr.edu/aedi/

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