Financial Policy Working Papers

Alternative Nominal Anchors: A Welfare Comparison

Banking and Policy Working Paper 4-03 (This draft: September 2003; First draft: June 2003)

Jangryoul Kim

Published September 1, 2003

This paper compares the performances of three alternative nominal anchors, i.e., price inflation, nominal income growth, and money growth in an estimated monetary business cycle model. The representative household's lifetime utility is used as a natural welfare metric, and the welfare effects of the non-linear dynamics are captured by a quadratic approximate solution method. Strict inflation targeting is a feasible and desirable choice only when the economy has to run high rates of long-run inflation. When the long-run inflation rate is close to zero, strict targeting of the other two anchors yields comparably higher welfare level than a feasible inflation targeting, since the efficiency gains from lower long-run inflation and nominal interest rates outweigh the welfare effects of short-run inflation stabilization. The author is an economic analyst in the special studies and policy section of the Federal Reserve Bank of Minneapolis. The views expressed are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Minneapolis, the Board of Governors, or the Federal Reserve System.