Optimal Monetary Policy

In this chapter, we derive optimal monetary policy when the central bank minimizes welfare losses arising from price dispersion among different goods. We show that welfare losses can be captured by a quadratic loss function as second order Taylor approximation. The optimal policy response crucially depends on the specific nature of the underlying shock. Both for demand and supply shocks it is optimal to stabilize the price level, thus minimizing price distortions. Keeping price stable, output will stay at potential. In the presence of mark-up shocks, however, there is a trade-off between implementing price stability and bringing output close to the efficient level.Since market equilibrium is inefficiently low due to distortions, there is an incentive for a welfare maximizing central bank to trigger a surprise inflation. We characterize the problem of dynamic consistency using game theoretic concepts: The attempt to raise welfare results just in an inefficiently high price level, since the central bank cannot systematically raise output above market equilibrium.We discuss various mechanisms to impose binding rules as commitment mechanism. Since the adequate response depends on the nature of specific shocks, mechanical simple instrument rules are shown to be sub-optimal. Instead, targeting rules allow the use of all relevant information. They specify conditions for the (forecasts of) target variables, leaving the instruments at the discretion of the central bank.