Optimal Interest-Rate Rules in a Forward-Looking Model, and Inflation Stabilization versus Price-Level Stabilization
This paper characterizes the properties of various interest-rate rules in a basic forward-looking model. We compare simple Taylor rules and rules that respond to price-level fluctuations (called Wicksellian rules). We argue that by introducing an appropriate amount of history dependence in policy, Wicksellian rules perform better than optimal Taylor rules in terms of welfare, robustness to alternative shock processes, and are less prone to equilibrium indeterminacy. A simple Wicksellian rule augmented with a high degree of interest rate inertia resembles a robustly optimal rule, i.e., a monetary policy rule that implements the optimal plan and that is also completely robust to the specification of exogenous shock processes.
This is a substantially revised version of chapter 1 of my Ph.D. dissertation. I wish to thank Jean Boivin, Bruce Preston and Michael Woodford for very valuable discussions. I am grateful to the NSF for financial support under the grant SES-0518770. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.