Optimal Choice of Monetary Instruments in an Economy with Real and Liquidity Shocks

Poole (QJE, 1970) using a stochastic IS-LM model presented the …rst formal treatment of the classic question: how should a monetary authority decide whether to use the money stock or the interest rate as the policy instrument. We update the seminal work of Poole in a microfounded ‡exible-price general equilibrium model of money using explicit welfare criteria. Speci…cally, we study the optimal choice of monetary policy instruments in a overlapping-generations economy where limited communication and stochastic relocation creates an endogenous transactions role for …at money. We characterize stationary welfare maximizing monetary and in‡ation targets for settings in which the economy is separately hit with i.i.d endowment and liquidity shocks. Our analysis suggests that the central insight of Poole survives: when the shocks are real (nominal and not large), welfare is higher under money growth (in‡ation rate) targeting. Date : April 27, 2005. We thank the participants of the No-Free-Lunch workshop at ISU for comments, and to Soumen Lahiri and Krishna Athreya for “technical”assistance. Bhattacharya: [email protected] Singh: [email protected]. 1 2 JOYDEEP BHATTACHARYA AND RAJESH SINGH