Endogenous monetary policy and the business cycle

The correlations and volatilities of real variables seem to be stable over time, but the relation between real and nominal variables is unstable. Presumably, one important factor behind this observation is the nature of money supply. In this paper, I look at a business cycle model where the central bank sets money supply to minimize the volatility of inflation and output. I find that small changes in the central bank's preferences can generate large changes in the derived money supply rule and in correlations between real and nominal variables. Although wages are assumed to be sticky, changes in the money supply rule do not generate any major changes in the behavior of real variables. (C) 2000 Elsevier Science B.V. All rights reserved. JEL Classification: E32; E52.