equal their respective steady state of zero. Accordingly, in such circumstances, the process for financial conditions η t would approximately reduce to η t + λ η η t − 1 + λ η η η t − 2 . This shows that under full output gap stabilization, η t would only depend on its own lags. It follows that if we initialized the system in its steady state, then financial conditions would stay in that steady state forever. As a consequence, vulnerability would also be
’s welfare as a metric. Results show that strict headline inflation targeting could be easily dominated by sectoral inflation targeting, output gap stabilization, or a combination of these. The appropriate monetary policy to adopt in the presence of subsidized prices and costly adjusting of prices is sensitive to the relative importance of the two distortions. Also, the way governments finance subsidies is crucial for designing the optimized monetary rule. Interestingly, we find cases where price subsidies are relatively more distorting than nominal price inertia in the
Figure 2. The monetary policy frontier under a dual mandate Figure 3. The volatility of welfare-relevant variables under a dual mandate Figure 4. Welfare losses under extended mandates Figure 5. Policy frontiers for the financial stabilization objective Figure 6. Policy frontiers for the output gap stabilization objective Figure 7. Dual mandate with alternative resource utilization measures Figure 8. The role of mark-up shocks Figure 9. Volatility as a function of the weight on interest rate smoothing Tables Table 1. Data series, data transformations
in a standard inflation-output gap loss function in a framework with both wage and price stickiness. However, the analysis with the canonical model demonstrates that the merits of a dual mandate depend on the structure of the economy (distortions in goods and labor markets) as well as shocks creating a trade-off between inflation and output gap stabilization. We therefore complement this analysis with numerical simulations in an estimated medium-scale model. Specifically, we use the workhorse Smets and Wouters (2007) empirical model—SW henceforth—of the U
on euro area data. 3 Our main finding is that assigning a financial stabilization objective to monetary policy, alongside its traditional remit for inflation and output gap stabilization, yields welfare benefits comparable to those of the Ramsey policy. A ternary financial stabilization objective is therefore highly desirable, as it delivers welfare outcomes that are close to the best achievable, but with a remit that is easily codified and communicated. The key insight that our exercise provides is that financial frictions are welfare-relevant, but at the same