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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: gavin@stls.frb.org.
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Abstract

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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

Information

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

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