Evaluating Monetary Policy Regimes: The Role of Nominal Rigidities

Abstract

I compare four basic monetary policy rules belonging to the interest-rate pegging rules class in two different analystical frameworks representing the way through which nominal rigidities are designed. A first model consider the Calvo-Woodford mechanism of price adjustment, as has become customary in the literature on monetary policy rules. A second model, instead, considers the cost of price adjustment function, as proposed by Rotemberg (1982). The two models are simulated to find the optimal monetary policy rule, maximizing the welfare of the representative agent. The results show that the optimal monetary policy rule for the model based on the Calvo price setting method is a simple contemporaneous interest-pegging rule with a lagged nominal interest rate. However, with a model based on the cost of price adjustment, the optimal rule is given by an interest rate rule with a expected inflation, contemporaneous output gap and a lagged interes rate term as arguments. Impulse respnse functions for different vallues of the parameters of the respective optimal monetary poliy function are plotted for both models, for an expansionary public expenditure shock and a contractionary monetary policy shock. The calculation of the model are empirically robust. For the first time fiscal policy is explicitly inserted in the model through a ’Passive’ tax policy rule. An explicit analysi f about the determinacy of the equilibrium is contained in the model.