Introduction

Monetary authorities have traditionally pursued a price stability goal. Economic theory recommends that the monetary authorities should pursue either a price stability goal or establish an inflation rate corresponding to full liquidity, that is, inflation equal to the negative of the marginal productivity of capital (Fischer and Modigliani, 1978; Friedman, 1969). A price stability goal can be explained by the consideration to minimise menu costs associated with price changes and costs associated with information collection. The full liquidity rule is explained by the consideration to increase the efficiency of money. Optimal inflation may be derived from a balance between these goals, see for example Turnovsky (1987b). The pursuit of a specific inflation rate makes it possible to avoid the wealth transfers between holders and issuers of fixed interest securities caused by unexpected inflation.

What is important for this analysis is that the authorities pursue a goal of a specific inflation rate. This implies that the authorities' preferences become asymmetric: for rates of inflation above the optimal rate, both employment and inflation goals are pursued while for inflation rates below the optimal rate a production goal exclusively is pursued. In the case where optimal inflation has been realised, the authorities are free to increase employment through monetary policy.