Optimal Interest Rate Rules and Inflation Stabilization versus Price-Level Stabilization

This paper presents preliminary fi ndings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the author and are not necessarily refl ective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author. for very valuable discussions as well as the National Science Foundation for fi nancial support under grant SES-0518770. The views expressed in this paper are those of the author and do not necessarily refl ect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Abstract This paper compares the properties of interest rate rules such as simple Taylor rules and rules that respond to price-level fl uctuations—called Wicksellian rules—in a basic forward-looking model. By introducing appropriate history dependence in policy, Wicksellian rules perform better than optimal Taylor rules in terms of welfare and robustness to alternative shock processes, and they are less prone to equilibrium indeterminacy. A simple Wicksellian rule augmented with a high degree of interest rate inertia resembles a robustly optimal rule—that is, a monetary policy rule that implements the optimal plan and is also completely robust to the specifi cation of exogenous shock processes.