We compare optimal and simple interest-rate rules. Our model features optimizing agents, monopolistic competition in both product and labor markets, and one-period nominal contracts (for wages alone or for both wages and prices) signed before shocks are known. Exact solutions ensure that we obtain correct welfare rankings. Optimal rules maximize the unconditional expected utility of the representative agent with commitment subject to the information set of the policymaker. Even with monopolistic distortions, the optimal full-information rule makes the economy mimic the hypothetical full-flexibility equilibrium. Strict versions of inflation targeting, nominal-income-growth targeting, and other such simple rules are suboptimal under both full and partial information but flexible versions are optimal under certain partial-information assumptions. Nominal-income-growth targeting dominates inflation targeting for plausible parameter values.
Bibliographical noteFunding Information:
The authors would like to acknowledge the help of Corrado Di Maria, Claire Hausman, Kevin Lansing, Kristian Rogers, Morten Spange, and Robert Usarek. We have benefited greatly from the comments of an anonymous referee. Kim's work on this project was supported in part by a Bankard grant from the University of Virginia. The views in this paper are solely the responsibility of the authors and should be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.
- Inflation targeting
- Interest-rate rule
- Nominal-income-growth targeting
- Optimal monetary policy
- Wage and price contracts
ASJC Scopus subject areas
- Economics and Econometrics