Interest Rate Rules vs. Money Growth Rules: A Welfare Comparison in a Cash-In-Advance Economy

This paper considers the welfare consequences of two particularly simple rules for monetary policy: an interest rate peg and a money growth peg. The model economy consists of a real side that is the standard real business cycle model, and a monetary side that amounts to imposing cash-in-advance constraints on certain market transactions.The paper also considers the effect of assuming a rigidity in the typical household’s cash savings choice. The competitive equilibrium of the economy is not Pareto efficient, partly because of two intertemporal distortions: a distortion on the capital accumulation decision, and a distortion on portfolio choice that arises from the assumed rigidity. The principal result of the paper is that the interest rate rule (but not the money growth rule) entirely eliminates these two intertemporal distortions and is thus the benevolent central banker’s policy choice.