Working Paper: NBER ID: w1881
Authors: Joshua Aizenman; Jacob A. Frenkel
Abstract: This paper develops an analytical framework for the analysis of targeting rules for monetary policy. We derive the optimal money supply rule and analyze the implications of other monetary rules including rules that target nominal GNP, the price level, the monetary growth rate and the interestrate. An explicit welfare criterion is used in order to rank the alternative rules. In the model monetary policy is needed because labor market contracts set nominal wages in advance of the realization of the stochastic shocks. The principal result is that the welfare ranking of alternative targeting rules depends on whether the elasticity of labor demand exceeds or falls short of the elasticity of labor supply. Specifically, it is shown that if the demand for labor is more elastic than the supply, then targeting nominal GNP produces a smaller welfare loss than targeting the CPI which in turn produces a smaller welfare loss than interest rate targeting.
Keywords: monetary policy; targeting rules; welfare loss
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| targeting nominal GNP (E10) | smaller welfare loss (D69) |
| targeting CPI (C43) | smaller welfare loss (D69) |
| targeting interest rate (E43) | larger welfare loss (D69) |
| elasticity of labor demand more than supply (J20) | targeting nominal GNP leads to smaller welfare loss (D69) |
| optimal money supply rule (E51) | eliminates welfare loss (D69) |
| constant money growth rule (O42) | larger welfare losses than nominal GNP targeting (D69) |