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Federal Reserve Bank of Philadelphia
Working Papers
Interest rate versus money supply instruments: on the implementation of Markov-perfect optimal monetary policy
Michael Dotsey
Andreas Hornstein
Abstract

Currently there is a growing literature exploring the features of optimal monetary policy in New Keynesian models under both commitment and discretion. With respect to time consistent policy, the literature focuses on solving for allocations. Recently, however, King and Wolman (2004) have examined implementation issues involved under time consistent policy when the monetary authority chooses nominal money balances. Surprisingly, they find that equilibria are no longer unique under a money stock regime. Indeed, there exist multiple steady states. Dotsey and Hornstein find that King and Wolman's conclusion of non-uniqueness of Markov-perfect equilibria is sensitive to the instrument of choice. If, instead, the monetary authority chooses the nominal interest rate rather than nominal money balances, there exists a unique Markov-perfect steady state and point-in-time equilibria are unique as well. Thus, in King and Wolman's language, monetary policy is implementable using an interest rate instrument while it is not implementable using a money stock instrument.


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Michael Dotsey & Andreas Hornstein, Interest rate versus money supply instruments: on the implementation of Markov-perfect optimal monetary policy, Federal Reserve Bank of Philadelphia, Working Papers 07-27, 2007.
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Keywords: Markov processes ; Monetary policy ; Money supply
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