Abstract
This paper examines the monetary instrument choice problem in models with an explicit supply sector and endogenous prices and price expectations. We use the popular linear-quadratic certainty-equivalence framework to obtain analytic solutions. The results indicate that interest rate policies generally are better able to insulate the real sector from unanticipated supply shocks. We also show that at this level of abstraction the optimal choice of an instrument is independent of the specification of expectations, e.g., rational vs. adaptive price expectations. The paper then reports empirical evidence from two experiments on the large nonlinear MIT-PENN-SSRC econometric model. The evidence is consistent with the hypothesis that interest rate policies are preferable if the supply sector is the major source of uncertainty.
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