Optimal Monetary Policy and the Correlation between Prices and Output

• Published in: Contributions to macroeconomics Vol. 3; no. 1; p. 1064
• Main Authors: Cover, James Peery, Pecorino, Paul
• Format: Journal Article
• Language: English
• Published: Berkeley De Gruyter 25.02.2003; Berkeley Electronic Press
• Subjects: Business cycles; Correlation analysis; Economic models; History; Inflation; Keynesian theory; Macroeconomics; Market prices; Monetary policy; Output rate; Price levels; Price-output correlation; Prices; Studies; Supply & demand; Supply and demand; U.S.A; United States > US
• ISSN: 1534-6005; 1534-6005
• DOI: 10.2202/1534-6005.1064

Several empirical papers have established the fact of a negative price-output correlation for the United States in the post WWII era. Much of this work appears to interpret the sign of this correlation under the assumption that monetary policy is passive. This paper uses a simple aggregate supply and demand model to examine how an optimizing monetary policy affects the price-output correlation. The model is capable of explaining why the price-output correlation in the United States is positive with prewar data but negative with postwar data. The model implies that a negative price-output correlation can emerge under an optimal policy only if policymakers are concerned with both inflation and output and the underlying economy is one in which both demand and supply shocks affect output. The model implies that a negative price-output correlation is inconsistent with real business cycle models, while a positive correlation does not necessarily support the use of neo-Keynesian models.