TY - JOUR AU - Khan,Aubhik AU - King,Robert G. AU - Wolman,Alexander L. TI - Optimal Monetary Policy JF - National Bureau of Economic Research Working Paper Series VL - No. 9402 PY - 2002 Y2 - December 2002 UR - http://www.nber.org/papers/w9402 L1 - http://www.nber.org/papers/w9402.pdf N1 - Author contact info: Aubhik Khan Department of Economics Ohio State University 410 Arps Hall 1945 N. High Street Columbus, OH 43210 Tel: 614 247 0097 E-Mail: mail@aubhik-khan.net Robert King Department of Economics Boston University 270 Bay State Road Boston, MA 02215 Tel: 617/353-5941 E-Mail: rking@bu.edu Alexander L. Wolman Research Department Federal Reserve Bank of Richmond P.O. Box 27622 Richmond, VA 23261 Tel: 804/697-8262 Fax: 804/697-8217 E-Mail: alexander.wolman@rich.frb.org AB - Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two sets of frictions -- costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods -- we find optimal monetary policy is governed by two familiar principles. First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate. Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those which would occur if prices were flexible. In our benchmark model, there is some tendency for the monetary authority to smooth nominal and real interest rates. ER -