Trend growth and optimal monetary policy q Fabrizio Mattesini a , Salvatore Nisticò b, * a Università di Roma, Tor Vergata, Via Columbia 2, 00133 Rome, Italy b Università di Roma, Tor Vergata and LUISS Guido Carli, Viale Romania 32, 00197 Rome, Italy article info Article history: Received 3 February 2009 Accepted 26 February 2010 Available online 16 March 2010 JEL classification: E12 E44 E52 Keywords: Trend growth Optimal monetary policy Commitment abstract This paper analyzes the optimal behavior of the Central Bank in an economy characterized by balanced growth. We show how trend-growth affects the dynamics of inflation, the preferences of a welfare-maximizing Central Bank and optimal monetary policy. In partic- ular, we show that the optimal monetary policy response to cost-push shocks is not invari- ant to trend growth, and that countries with lower trend growth have substantially higher incentives to commit to simple rules, both from a welfare and price-stability perspectives. Ó 2010 Elsevier Inc. All rights reserved. 1. Introduction Modern dynamic macroeconomic theory, both in the original real business cycle version and in the more recent New Key- nesian framework, views business cycles as fluctuations around a constant linear trend, which are produced by short-run, persistent shocks of various nature. The trend is meant to capture the ‘‘balanced growth property” of the neoclassical growth model, according to which, when technology is represented by a constant returns production function with labor augment- ing technical progress, macroeconomic variables like output, consumption and the stock of physical capital display a similar average rate of growth over sufficiently long periods of time. Although trend growth is an essential characteristics of dynamic macroeconomics, however, theoretical models usually abstract from it and set it to zero. 1 New Keynesian models, in particular, tend to focus on monetary policy and on the tradeoff between inflation and short-run deviations of output from its potential level, without worrying about the long-run evolution of potential output. Is this an innocuous simplification? Indeed, the recent debate on monetary policy suggests that the question of how Central Banks should respond to tech- nological progress is an important issue. Until the burst of the ‘‘dot.com” bubble and the recent financial crisis, the ability 0164-0704/$ - see front matter Ó 2010 Elsevier Inc. All rights reserved. doi:10.1016/j.jmacro.2010.02.001 q The authors wish to thank Theodeore Palivos (Editor) and an anonymous referee for very insightful comments. We also thank Giorgio Di Giorgio, Alessia Isopi, Francesco Lippi, and seminar participants at Ente Einaudi, LUISS Guido Carli, Università di Roma Tor Vergata, and the XIV International ‘‘Tor Vergata” Conference on Banking and Finance for useful discussions and comments. The usual disclaimer applies. * Corresponding author. Tel./fax: +39 6 85225724. E-mail addresses: fabrizio.mattesini@uniroma2.it (F. Mattesini), snistico@luiss.it (S. Nisticò). 1 The use of trend growth, instead, is becoming increasingly popular in the estimation of quantitative DSGE models, such as Smets and Wouters (2007), Justiniano and Primiceri (2008) and Castelnuovo and Nisticò (2008), among the others. These papers, however, introduce trend growth mainly to allow for a model-consistent de-trending of data, but do not explore the consequences of trend growth for the system dynamics and the policy design. Journal of Macroeconomics 32 (2010) 797–815 Contents lists available at ScienceDirect Journal of Macroeconomics journal homepage: www.elsevier.com/locate/jmacro