RDP 9812: An Optimising Model for Monetary Policy Analysis: Can Habit Formation Help? 7. Welfare Considerations

Having identified the utility parameters in this simple monetary policy model, it is tempting to use the model to compute the welfare implications of alternative monetary policy strategies. That is, after all, the ultimate goal in developing models of this type.

However, I would hesitate to do so with this model, for several reasons. First, given the empirical significance of consumers who appear to follow a rule of thumb, it is difficult to know whose utility we should maximise in evaluating policy alternatives. One could maximise the utility of the (forward-looking, rational) habit-formation consumers, but one could not know the welfare implications for the rule-of-thumbers.

Second, the model as it stands includes no explicit cost of inflation! The agents in the model know that the Fed cares about deviations of inflation from target (insofar as this motive is reflected in the reaction function). They know that, as a result, the Fed will cause real disruptions in order to move inflation back towards its target when it deviates, and these real disruptions will cause them to suffer welfare losses. However, it is only through these indirect effects that inflation affects consumers. Without any direct cost of inflation, the optimal policy from the consumers' point of view is one that minimises fluctuations in consumption. This is not a satisfying or interesting policy conclusion.

Finally, the representative agent nature of this model makes welfare analysis somewhat suspect. Because the bulk of the welfare cost arguably arises from discrete shifts in employment status for a small fraction of the population, the representative agent model may not provide an accurate measure of the relative welfare costs of pursuing different monetary policies.

A commonly used alternative is to posit an indirect utility function or approximate loss function that depends on a weighted average of output deviations (around potential) and inflation deviations (around the Fed's target for inflation). Although the mapping between this loss function and utility cannot be known a priori, this may be a reasonable approximation to use until the thornier issues of explicitly modelling inflation losses and characterising welfare in a nonrepresentative agent framework are tackled. I leave the computation of ‘optimal’ policy responses in this model for future work.