Supply Shocks and Optimal Monetary Policy

Abstract

This paper demonstrates that if current shocks are observed instantaneously, output can be stabilized perfectly for completely general supply disturbances, using simple monetary rules based only on: (i) the current shock, (ii) the previous forecast of the current shock, (iii) the forecast for just one period ahead.The optimal rule can be expressed in an infinite number of ways and various alternatives are considered.With optimal wage indexation, the monetary rule is even simpler.If current shocks are not observed instantaneously, but are inferred from other signals, the optimal rules are of the same form, with the current perceived disturbance replacing the actual.

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