On the Economic Distortions of Smoothing Aggregate Volatility with Monetary Policy

Monetary policy is a blunt instrument with which to smooth aggregate volatility. I demonstrate that there is actually very little correlation between how much real state income responds to monetary policy and to shocks that prompt aggregate smoothing by the Federal Reserve. This mismatch turns out to be strong enough to imply that while monetary policy might have reduced the variance of aggregate output in the US over the last three decades, it has actually increased the variance of output in a majority of states. Moreover, policy rules that minimize aggregate variance are not equal in the severity of distortions they create in the volatility of state income. Optimal rules that place more weight on price variance typically create the largest distortions while those that place weight on aggregate income volatility create the smallest. In the end, monetary policy has the potential to create large distortions, but need not do so. ∗Banking Studies Function, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10029, (212) 720-1617, [email protected]. Sincere thanks to Olivier Blanchard and Daron Acemoglu for their endless advice. Any remaining errors in this paper are my own, and the opinions expressed here do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.