Research Discussion Papers, Bank of Finland
Inflation Targeting and the Role of Money in a Model with Sticky Prices and Sticky Money
Abstract: In order to study the role of money in an inflation
targeting regime for monetary policy, we compare the interest rate and
money as monetary policy instruments. Our dynamic stochastic general
equilibrium model combines the money-in-the utility-function approach with
sticky prices. We allow for time-varying preferences for real money
balances, ie velocity shocks, and stochastic aggregate costs in production,
ie 'technology shocks'. We show that conditioning the interest rate on the
expected future cost change can be used to achieve constant inflation or
constant inflation expectations. The assumed adjustment costs in 'money
demand' lead to an equilibrium in which inflation can be controlled by
money growth without information on the current state of the economy.
Finally, we discuss the tradeoff between money and the interest rate as a
monetary policy instrument. The result depends on the parameter stability
of the cost change process relative to that of the 'money demand'
Keywords: monetary transmission mechanism; money-in-the-utility-function model; sticky prices; technology shock; monetary policy strategy; (follow links to similar papers)
JEL-Codes: E31; E41; E52; (follow links to similar papers)
34 pages, November 19, 1997
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