2023 Volume 5 Pages 22-46
By solving a dynamic optimization structure, this paper aims to achieve an optimal monetary policy which enables the central bank to minimize a Taylor-rule embedded social loss function of inflation and employment. Three different types of inflation expectations are tested: forward-looking, backward-looking, and mixed expectation formation. As a result, under several assumptions, we found stable and optimal policy paths with all of the three scenarios. The results suggest that when the expected inflation rate is below the target, the central bankers need to initially set the interest rate at a sufficiently low level but gradually raise it, until they reach the equilibrium. Opposite solution stands if the inflation expectation is above the target. These may be counterfactual to a commonly seen monetary policy, though we believe this analysis is meaningful, in a way that our solution can be regarded as a “reference” or “yardstick”, and indicate how the real-life monetary policy is deviating from the optimal path.
