Working Paper BETA #2010-19

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Title : Financial market imperfections and monetary policy strategy

Author(s) : Meixing DAI

Abstract : In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank using the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if the access to liquidity is subject to non-price rationing, the central bank can use a narrow monetary aggregate and the discount interest rate as independent policy instruments to reinforce the credibility of its announcements and the role of inflation target as nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman’s k-percent money growth rule, generating dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.

Key-words : Imperfect financial markets, non-price rationing, inflation targeting, monetary targeting, macroeconomic stability, Friedman’s k-percent rule, feedback money growth rules, two-pillar strategy.

JEL Classification : E44, E52, E58