Working Paper: CEPR ID: DP4654
Authors: Stephanie Schmitt-Grohé; Martin Uribe
Abstract: This Paper identifies optimal interest-rate rules within a rich, dynamic, general equilibrium model that has been shown to account well for observed aggregate dynamics in the post-war United States. We perform policy evaluations based on second-order accurate approximations to conditional and unconditional expected welfare. We require that interest-rate rules be operational, in the sense that they include as arguments only a few readily observable macroeconomic indicators and respect the zero bound on nominal interest rates. We find that the optimal operational monetary policy is a real-interest-rate targeting rule. That is, an interest-rate feedback rule featuring a unit inflation coefficient, a mute response to output, and no interest-rate smoothing. Contrary to existing studies, we find a significant degree of optimal inflation volatility. A key factor driving this result is the assumption of indexation to past inflation. Under indexation to long-run inflation the optimal inflation volatility is close to zero. Finally, we show that initial conditions matter for welfare rankings of policies.
Keywords: business cycles; inflation stabilization; monetary policy evaluation
JEL Codes: E52; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal operational monetary policy should be characterized by a real interest-rate targeting rule (E52) | optimal inflation volatility is desirable (E31) |
| initial conditions matter for the welfare rankings of policies (D69) | evaluation of monetary policy must consider transitional dynamics of the economy (E61) |
| assumption of indexation to past inflation (E31) | optimal inflation volatility is significant (E31) |
| indexation to long-run inflation (E31) | optimal inflation volatility approaches zero (E31) |