Price-Level and Interest-Rate Targeting in a Model with Sticky Prices

This paper examines a standard sticky price monetary model. The equilibrium conditions of the model are perturbed relative to the canonical real business cycle model by two varying distortions: marginal cost and the nominal rate of interest. The paper explores the implications of two monetary policies that are frequently advocated: (1) an inflation target and (2) an interest rate target. Under an inflation rate target, marginal cost is stabilized while the nominal rate is variable. In contrast, under an interest rate target, the nominal rate is stabilized but marginal cost is (in general) variable. Both policies are subject to sunspot fluctuations arising from the endogenous movement of the money stock. These fluctuations can be avoided by eliminating the contemporaneous response of the money stock to innovations in the environment.