Money Talks and Matters:

How should central banks conduct and communicate their policies to serve the goal of stabilizing the macroeconomy? This thesis – consisting of three self-contained essays on dynamic macroeconomics – is mainly intended as a progress report on exploring the normative aspect of monetary policy. The main result of the first essay is, that in the presence of idiosyncratic risk, the public revelation of information about uncertain aggregate outcomes can be detrimental. By announcing informative signals on non-insurable aggregate risk, the policy maker distorts agents’ insurance incentives and increases the riskiness of the optimal allocation that is feasible in self-enforceable arrangements. We consider a monetary authority that may reveal changes in the inflation target, and document that the negative effect of distorted insurance incentives can very well dominate conventional effects in favor for the release of better information. In the second essay, we study optimal monetary policy with the nominal interest rate as the single policy instrument. Firms set prices in a staggered way without indexation and real money balances contribute separately to households’ utility. The optimal deterministic steady state under commitment is the Friedman rule for a broad range of parameters. Optimal monetary policy in the short run is then characterized by stabilization of the nominal interest rate instead of inflation stabilization as the predominant principle. In the third essay, I examine whether the existence and the timing of real balance effects contribute to the determination of the absolute price level. As the main novel result, I show that there exists a unique price level sequence that is consistent with an equilibrium under interest rate policy, if beginning-of-period money yields transaction services. Predetermined real money balances can then serve as a state variable, implying that interest rate setting should be passive – a violation of the Taylor-principle.