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Title: Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the US Business Cycle

Author(s): Stephanie Schmitt-Groh� and Mart�n Uribe

Publication Date: October 2004

Keyword(s): business cycles, inflation stabilization and monetary policy evaluation

Programme Area(s): International Macroeconomics

Abstract: This Paper identifies optimal interest-rate rules within a rich, dynamic, general equilibrium model that has been shown to account well for observed aggregate dynamics in the post-war United States. We perform policy evaluations based on second-order accurate approximations to conditional and unconditional expected welfare. We require that interest-rate rules be operational, in the sense that they include as arguments only a few readily observable macroeconomic indicators and respect the zero bound on nominal interest rates. We find that the optimal operational monetary policy is a real-interest-rate targeting rule. That is, an interest-rate feedback rule featuring a unit inflation coefficient, a mute response to output, and no interest-rate smoothing. Contrary to existing studies, we find a significant degree of optimal inflation volatility. A key factor driving this result is the assumption of indexation to past inflation. Under indexation to long-run inflation the optimal inflation volatility is close to zero. Finally, we show that initial conditions matter for welfare rankings of policies.

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Bibliographic Reference

Schmitt-Groh�, S and Uribe, M. 2004. 'Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the US Business Cycle'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4654