Optimal Monetary Policy for Taiwan: A Dynamic Stochastic General Equilibrium Framework

Abstract

The objective of this paper is to investigate the monetary policy of Taiwan by using a micro-based dynamic stochastic general equilibrium (DSGE) model with a banking sector. Because Taiwan's central bank has claimed to use the M2 aggregate growth rate as the monetary target since 1992, this study essentially centers on the welfare assessments of the optimized money growth rate rule and the alternative Taylor-type interest rate rule. We find that the money growth rate rule plays a better job in stabilization and is welfare dominating over the interest rate rule for all types of real shocks. Due to the liquidity effects that the monetary aggregate supplies for consumption, controlling the growth rate of the monetary aggregate can successfully reduce both the inflation and output volatilities. The welfare superiority of the monetary aggregate rule holds for alternative specifications of the model, including the frictionless credit market, the lower international capital mobility and lower nominal rigidity. The current monetary policy, estimated by Teo (2009), follows in a similar fashion to the optimized monetary policy that this study suggests, but has smaller effects in stabilizing the CPI inflation and exchange rates. Reinforcing its endeavors in inflation and exchange rate stabilization can be welfare improving.