April 1999 (Revised July 2004)

Exact Utilities under Alternative Monetary Rules in a Simple Macro Model with Optimizing Agents

Dale W. Henderson and Jinill Kim


We construct an optimizing-agent model of a closed economy which is simple enough that we can use it to make exact utility calculations. There is a stabilization problem because there are one-period nominal contracts for wages, or prices, or both and shocks that are unknown at the time when contracts are signed. We evaluate alternative monetary policy rules using the utility function of the representative agent. Fully optimal policy can attain the Pareto-optimal equilibrium. Fully optimal policy is contrasted with both 'naive' and 'sophisticated' simple rules that involve, respectively, complete stabilization and optimal stabilization of one variable or a combination of two variables. With wage contracts, outcomes depend crucially on whether there are also price contracts. For example, if labor supply is relatively inelastic, for productivity shocks, nominal income stabilization yields higher welfare when there are no price contracts. However, with price contracts, outcomes are independent of whether there are wage contracts, except, of course, for the nominal wage.

Original version (694 KB PDF)

Keywords: Monetary policy, stabilization, sticky wages, sticky prices, wage contracts, price contracts, inflation targeting, price level targeting, money supply targeting, disequilibrium models

PDF: Full Paper

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Last Update: February 05, 2021