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Monetary policy and economic growth: combining short and long run macro analysis

By Orlando Gomes

Abstract

The new Keynesian monetary policy model studies the response of the inflation – output gap trade-off to policy decisions taken by the Central Bank, concerning the nominal interest rate time trajectory. Under an optimal setup, this model displays a saddle-path stable equilibrium and, if the stable trajectory is followed, the steady state is characterized by an inflation rate that coincides with the selected inflation target. A high inflation target has positive effects over the rise of effective output relatively to its potential level (the monetary policy problem captures this effect), but it has a perverse impact over investment decisions (the referred problem does not capture this effect, taking it as granted). This second relation can be understood by associating to the first macro model a second setup, which takes consumption and investment decisions, i.e., by considering a long term growth setup. The link between the two is present on the impact of inflation over investment decisions. With this integrated framework one is able to simultaneously study short and long-run macroeconomic phenomena and to jointly analyze the behaviour of nominal and real aggregates. The most important results consist on the determination of an optimal inflation target and on the consideration of short term supply shocks as having a long-run impact producing business cycles.Monetary policy; Economic growth; Inflation targeting; Output gap

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