Welfare Evaluation of Monetary Policy Rules in a Model with Nominal Rigidities

Banking and Policy Working Paper 3-03

Author: Jangryoul Kim
Federal Reserve Bank of Minneapolis

Paper: April 2003 [425k pdf]

Abstract

This paper examines the welfare implications of alternative monetary policy rules in a monetary business cycle model with nominal rigidities. The expected present discount utility of a representative household is used as the performance metric, and the welfare effects of the non-linear dynamics of the model are captured by the quadratic approximation method by Sims (2000). When the monetary authority aims at fixed paths of nominal variables, rules for fixed nominal income and money growth outperform fixed inflation rule. The former two rules in turn rank below variants of Taylor rules, under which the implicit target variables are adjusted gradually. The comparison of alternative rules also reveals that long run deflationary rules increase welfare. The welfare maximizing rule among a class of Taylor-style rules is characterized by i) super-inertial adjustments in interest rate; ii) strong short run anti-inflationary stance coupled with long run deflation, and iii) increasing nominal interest rates (i.e., leaning against the wind) in response to higher real output in both growth rates and levels.

The author is an economic analyst in the special studies and policy section of the Federal Reserve Bank of Minneapolis. The views expressed are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Minneapolis, the Board of Governors, or the Federal Reserve System.

The author welcomes your comments on this paper.