Optimal Monetary Policy
Theory and Lessons
V. V. Chari
University of Minnesota
and
Federal Reserve Bank of Minneapolis
Big Picture Lessons

Commitment best way to do policy
– Promise to do right thing is not commitment
– Gold standard is commitment

Rules only way to think of policy
– Inflation targeting is not a rule
– Taylor Rule is a rule

Optimality: Typically different responses to different shocks
– Taylor Rule does not have property
– Optimal policy depends on model details
Smaller Picture Lessons

Friedman Rule: Zero nominal interest rates + deflation

Standard Model: Friedman Rule optimal

Distorting Taxes: Friedman Rule still optimal

Sticky Prices: Get slight deflation

Punchline: In most models optimal inflation in [–3,0]
Friedman Rule

Private cost of money = nominal interest rate (R)

Social cost = 0

Hot potato problem

Policy: Set nominal interest rate to zero
Distorting Taxes

R = 0 implies deflation

Deflation needs declining M

Tax revenues needed to shrink M

Phelps: Trade off tax distortions versus hot potato problem

Surprisingly still get R = 0 with distorting taxes
Sticky Prices

Falling prices implies sectoral distortions

Want to keep price level constant

Want to get R to zero for hot potato reasons

Optimal policy is compromise (inflation in [–3,0])

Optimal policy responds differently to different shocks
○ Expand M in response to technology shocks
○ Contract M in response to fall in money demand
The Problems of Large Deflations

Households have endowment e

Cash-in-advance constraint

Prices stuck one period at a time
ct1
 1 
t

Preferences

Keep future P, output fixed
Pc  M
Inefficiency Possible

Equilibrium summarized by
○ Py  M , y  e

 P1 e 
   , i0
 P  y 
○ (1  i)  

As M , may hit i = 0 before y = e

Not much of a problem if
P
higher than –3 percent
P
Lessons for Policy Design

Commitment important

No consensus on detailed policy rule

How about
○ Pick policy rule for, say, 3 years
○ Require supermajority on FOMC to deviate from rule