This paper investigates how monetary policy should be conducted in a two-region, general equilibrium model with monopolistic competition and price stickiness. This framework delivers a simple welfare criterion based on the utility of the consumers that has the usual tradeoff between stabilizing inflation and output. If the two regions share the same degree of nominal rigidity, the terms of trade are completely insulated from monetary policy and the optimal outcome is obtained by targeting a weighted average of the regional inflation rates. These weights coincide with the economic sizes of the region. If the degrees of rigidity are different, the optimal plan implies a high degree of inertia in the inflation rate. But an inflation targeting policy in which higher weight is given to the inflation in the region with higher degree of nominal rigidity is nearly optimal.

Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast and has been called forecast targeting, and a high degree of transparency and accountability. It was introduced in New Zealand in 1990, has been very successful in terms of stabilizing both inflation and the real economy, and has, as of 2010, been adopted by about 25 industrialized and emerging-market economies. The chapter discusses the history, macroeconomic effects, theory, practice, and future of inflation targeting.

The optimal weights on indicators in models with partial information about the state of the economy and forward-looking variables are derived and interpreted, both for equilibria under discretion and under commitment. An example of optimal monetary policy with a partially observable potential output and a forward-looking indicator is examined. The optimal response to the optimal estimate of potential output displays certainty-equivalence, whereas the optimal response to the imperfect observation of output depends on the noise in this observation.

Abstract This paper considers the role of monetary aggregates in modern macroeconomic models of the New Keynesian type. The focus is on possible developments of these models that are suggested by the monetarist literature, and that in addition seem justified empirically. Both the relation between money and inflation, and between money and aggregate demand, are considered. Regarding the first relation, it is argued that both the mean and the dynamics of inflation in present-day models are governed by money growth. This relationship arises from a conventional aggregate-demand channel; claims that an emphasis on the link between monetary aggregates and inflation requires a direct channel connecting money and inflation, are wide of the mark. The relevance of money for aggregate demand, in turn, lies not via real balance effects (or any other justification for money in the IS equation), but on money's ability to serve as a proxy for the various substitution effects of monetary policy that exist when many asset prices matter for aggregate demand. This role for monetary aggregates, which is supported by empirical evidence, enhances the value of money to monetary policy.

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This paper studies the relationship between inflation, output, money and interest rates in the euro area, using data spanning 1980--2000. The P model is shown to have considerable empirical support. Thus, the "price gap" or, equivalently, the "real money gap" (the gap between current real balances and long-run equilibrium real balances), has substantial predictive power for future inflation. The real money gap contains more information about future inflation than the output gap and the Eurosystem's money-growth indicator (the gap between current M3 growth and a reference value). The results suggest that the Eurosystem's money-growth indicator is an inferior indicator of future inflation.

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The so-called P model is frequently used or referred to in discussions of monetary targeting. This gives the impression that the P model might provide some rationale for monetary targeting or for the monetary reference value used by the Eurosystem. The P model implies that ination is determined by the level of and changes in the real money gap (the deviation of current real balances from their long-run equilibrium level), and hence that the real money gap is an important indicator for future ination. Nevertheless, the P model does not seem to provide any rationale for either a Bundesbank-style money-growth target or a Eurosystem-style money-growth indicator. Keywords: Real balances, reference value, ination targeting JEL Classication Numbers: E42, E52, E58 I thank Paul De Grauwe, Stefan Gerlach, Berthold Herrendorf, Manfred Neumann, Karl-Heinz Tdter and Volker Wieland for comments on a previous version, Thomas Eisensee for research assistance and Christina Lnnblad for se...

We study optimal monetary policy design in a simple model that deviates from the linear-quadratic paradigm and provides a rationale for the practice of inflation zone targeting. We show that the presence of either zone-quadratic preferences or a zonelinear relationship between inflation and economic activity provides strong incentives to deviate from conventional linear policies. We calibrate the model based on parameters for the U.S. and the Euro area and employ a numerical dynamic programming algorithm to derive the optimal policies. With this algorithm, we examine the role of uncertainty, model structure and relative preference towards economic stability in determining the width of the implied targeted inflation zone.

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