Hostname: page-component-586b7cd67f-vdxz6 Total loading time: 0 Render date: 2024-11-26T17:08:07.708Z Has data issue: false hasContentIssue false
  • English
  • Français

INFLATION RISK AND OPTIMAL MONETARY POLICY

Published online by Cambridge University Press:  01 May 2009

William T. Gavin ,
Benjamin D. Keen  and
Michael R. Pakko
William T. Gavin*
Affiliation:
Federal Reserve Bank of St. Louis
Benjamin D. Keen
Affiliation:
University of Oklahoma
Michael R. Pakko
Affiliation:
Federal Reserve Bank of St. Louis
*
Address correspondence to: William T. Gavin, Vice President, Research Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166, USA; e-mail: [email protected].
Get access Rights & Permissions [Opens in a new window]

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 PolicyNominal RigiditiesInflation Risk
Type
Articles
Information
Macroeconomic Dynamics , Volume 13 , Supplement S1 , May 2009 , pp. 58 - 75
Copyright
Copyright © Cambridge University Press 2009

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

REFERENCES

Bansal, Ravi and Yaron, Amir (2004) Risks for the long run: A potential resolution of asset pricing puzzles. Journal of Finance 59, 1481–1509.CrossRefGoogle Scholar
Calvo, Guillermo A. (1983) Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383–398.Google Scholar
Canzoneri, Matthew B., Cumby, Robert E., and Diba, Behzad T. (2004) Price and wage inflation targeting: Variations on a theme by Erceg, Henderson, and Levin. In Faust, Jon, Orphanides, Athanasios, and Reifschneider, David (eds.), Models and Monetary Policy: Research in the Tradition of Dale Henderson, Richard Porter, and Peter Tinsley, pp. 181–125. Washington, DC: Board of Governors of the Federal Reserve System.Google Scholar
Canzoneri, Matthew B., Henderson, Dale, and Rogoff, Kenneth (1983) The information content of the interest rate and optimal monetary policy. Quarterly Journal of Economics 98, 545–566.CrossRefGoogle Scholar
Christiano, Lawrence J., Eichenbaum, Martin, and Evans, Charles L. (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113, 1–45.CrossRefGoogle Scholar
Clarida, Richard, Gali, Jordi, and Gertler, Mark (1999) The science of monetary policy: A New Keynesian perspective. Journal of Economic Literature 37, 1661–1707.CrossRefGoogle Scholar
Dittmar, Robert D. and Gavin, William T. (2005) Inflation targeting, price-path targeting and indeterminacy. Economics Letters 88, 336–342.Google Scholar
Dixit, Avinash and Stiglitz, Joseph (1977) Monopolistic competition and optimum product diversity. American Economic Review 57, 297–308.Google Scholar
Dueker, Michael J. (2000) Are prime rate changes asymmetric? Federal Reserve Bank of St. Louis Review: 82 33–40.Google Scholar
Erceg, Christopher, Henderson, Dale W., and Levin, Andrew (2000) Optimal monetary policy with staggered wage and price contracts. Journal of Monetary Economics 46, 281–313.CrossRefGoogle Scholar
Gallmeyer, Michael F., Hollifield, Burton, Palomino, Francisco, and Zin, Stanley E. (2007) Arbitrage-free bond pricing with dynamic macroeconomic models. Federal Reserve Bank of St. Louis Review 89, 305–326.Google Scholar
Gürkaynak, Refet S., Sack, Brian, and Swanson, Eric (2003) The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models. Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2003–50.Google Scholar
Hayashi, Fumio (1982) Tobin's marginal and average q: a neoclassical interpretation. Econometrica 50, 213–224.Google Scholar
Ireland, Peter N. (2007) Changes in the Federal Reserve's inflation target: Causes and consequences. Journal of Money, Credit and Banking 39, 1851–1882.Google Scholar
Keen, Benjamin D. (2004) In search of the liquidity effect in a modern monetary model. Journal of Monetary Economics 51, 1467–1494.CrossRefGoogle Scholar
Kim, Jinill and Henderson, Dale W. (2005) Inflation targeting and nominal income growth targeting: when and why are they suboptimal? Journal of Monetary Economics: 52 1463–1496.Google Scholar
King, Robert G. and Wolman, Alexander L. (1999) What should the monetary authority do when prices are sticky? In Taylor, John B. (ed.), Monetary Policy Rules, pp. 203–246. Chicago: Chicago University Press.Google Scholar
Kozicki, Sharon and Tinsley, Peter A. (2005) Permanent and transitory policy shocks in an empirical macro model with asymmetric information. Journal of Economic Dynamics and Control 29, 1985–2015.CrossRefGoogle Scholar
Levin, Andrew T., Onatski, Alexei, Williams, John C., and Williams, Noah (2005) Monetary policy under uncertainty in micro-founded macroeconomic models. In NBER Macroeconomic Annual, pp. 229–287. Cambridge, MA: MIT Press.Google Scholar
McCulloch, J. Huston and Kochin, Levis A. (2000) The Inflation Premium Implicit in the U.S. Real and Nominal Term Structures of Interest Rates. The Ohio State University Working Paper Series, No. 98–12.Google Scholar
Orphanides, Athanasios and Williams, John C. (2002) Robust monetary policy rules with unknown natural rates. Brookings Papers on Economic Activity 2, 63–118.CrossRefGoogle Scholar
Orphanides, Athanasios and Williams, John C. (2005) Inflation scares and forecast-based monetary policy. Review of Economic Dynamics 8, 498–527.Google Scholar
Reis, Ricardo (in press) The time-series properties of aggregate consumption: implications for the cost of fluctuations. Journal of the European Economic Association.Google Scholar
Rotemberg, Julio and Woodford, Michael (1992) Oligopolistic pricing and the effects of aggregate demand on economic activity. Journal of Political Economy 37, 505–533.Google Scholar
Rotemberg, Julio and Woodford, Michael (1997) An optimization-based econometric framework for the evaluation of monetary policy. In NBER Macroeconomics Annual, pp. 297–345. Cambridge, MA: MIT Press.Google Scholar
Rudebusch, Glenn D. and Svensson, Lars E.O. (1999) Policy rules for inflation targeting. In Taylor, John B. (ed.), Monetary Policy Rules, pp. 203–246. Chicago: University of Chicago Press.Google Scholar
Svensson, Lars E.O. (1999) Price-level targeting vs. inflation targeting: a free lunch? Journal of Money, Credit and Banking: 31 277–295.Google Scholar
Taylor, John B. (1993) Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195–214.CrossRefGoogle Scholar
Walsh, Carl E. (1998) Monetary Theory and Policy. Cambridge, MA: MIT Press.Google Scholar
Williams, John C. (2003) Simple rules for monetary policy. Federal Reserve Bank of San Francisco Economic Review, 1–12.Google Scholar
Woodford, Michael (2002) Inflation stabilization and welfare. Contributions to Macroeconomics 2, Article 1.Google Scholar
Woodford, Michael (2003) Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press.Google Scholar