Staff Report 394

On the Optimal Choice of a Monetary Policy Instrument

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
V. V. Chari | University of Minnesota, Federal Reserve Bank of Minneapolis
Andrew Atkeson | Consultant

Published August 1, 2007

The optimal choice of a monetary policy instrument depends on how tight and transparent the available instruments are and on whether policymakers can commit to future policies. Tightness is always desirable; transparency is only if policymakers cannot commit. Interest rates, which can be made endogenously tight, have a natural advantage over money growth and exchange rates, which cannot. As prices, interest and exchange rates are more transparent than money growth. All else equal, the best instrument is interest rates and the next-best, exchange rates. These findings are consistent with the observed instrument choices of developed and less-developed economies.

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