Optimal Monetary Policy

First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. (In modern language, there is only small “base drift” for the price level path as various shocks arise). Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate, i.e., with expected growth or contraction of real economic activity.

Although the monetary authority has substantial leverage over real activity in the authors' model economy, it chooses real allocations that closely resemble those that would occur if prices were flexible. In their benchmark model, the authors also find some tendency for the monetary authority to smooth nominal and real interest rates.