Working Paper: NBER ID: w16095
Authors: Michael Woodford
Abstract: This paper reviews the theory of optimal monetary stabilization policy, with an emphasis on developments since the publication of Woodford (2003). The structure of optimal policy commitments is considered, both when the objective of stabilization policy is defined by an arbitrarily specified quadratic loss function, and when the objective of policy is taken to be the maximization of expected utility. Issues treated include the time inconsistency of optimal policies and the need for commitment; the relation of optimal policy from a "timeless perspective" to the Ramsey conception of optimal policy; and the advantages of forecast targeting procedures as an approach to the implementation of optimal stabilization policy. The usefulness of characterizing optimal policy in terms of a target criterion is illustrated in a range of examples. These include models with a variety of assumptions about the nature of price and wage adjustment; models that allow for sectoral heterogeneity; cases in which policy must be conducted on the basis of imperfect information; and cases in which the zero lower bound on the policy rate constrains the conduct of policy.
Keywords: monetary policy; stabilization policy; inflation targeting
JEL Codes: E52; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| commitment to a policy framework (E61) | enhances the central bank's ability to stabilize inflation and output (E52) |
| shaping expectations about future policy (D84) | enhances the central bank's ability to stabilize inflation and output (E52) |
| discretionary policies (E60) | lead to suboptimal outcomes due to a lack of pre-commitment (D91) |
| optimal policy regime (E61) | expected long-run average inflation rate should be zero (E31) |
| cost-push shocks (E31) | create a tension between inflation and output stabilization goals (E31) |
| forecast targeting (C53) | serves as an effective mechanism for implementing optimal policy (D78) |
| aligning current actions with expected future outcomes (D84) | reinforces the credibility of the central bank's commitments (E58) |
| optimal response to disturbances (C62) | contingent upon the nature of those disturbances (C62) |