Working Paper: NBER ID: w10724
Authors: Stephanie Schmitt-Groh; MartÃn 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 postwar 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: monetary policy; interest-rate rules; dynamic general equilibrium
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 (E52) | inflation volatility (E31) |
| optimal operational monetary policy (E52) | overall welfare (I31) |
| indexation to past inflation (E31) | optimal inflation volatility (E31) |
| indexation to long-run inflation (E31) | optimal inflation volatility (E31) |
| initial conditions (C62) | welfare rankings (I30) |