Variance-minimizing Monetary Policies with Lagged Price Adjustment and Rational Expectations*

This paper considers a macroeconomic model with rational expectations in which prices are incompletely flexible. Markets therefore fail to clear. In such a model monetary policy is not neutral. The variance of real and nominal quantities and interest rates is sensitive to the parameters of the feedback rule that determines the money supply. The monetary policy that achieves the goat of minimizing the steady-state variance of real output is characterized. We also examine monetary policies that are restricted in their generality and derive ‘second-best’ variance-minimizing feedback rules.