Intervention in the Economy : Tradeoffs between Output and Volatility

In this article we study the tradeoffs between average output and reduced volatility due to macroeconomic intervention. Using a Keynesian model of regulated Brownian motion with an endogenous producer/investor term, we show that when intervention is perfect and costless, the rewards in terms of reduced volatility of output to be reaped from discretionary policy implementation are considerable. The rewards are greatest where bands are smallest and when the inherent volatility of the economy is greatest. However, when intervention costs are present, the price of reduced volatility is a reduction in average output. The reduction in output is greatest just where the rewards from reduced volatility are the highest. Moreover, when intervention costs are random or when the timing of intervention is imperfect, the potential for volatility reduction is reduced further. Importantly, we find that when intervention costs are present, there is no universal optimal intervention policy rule. The optimal intervention band depends on the economy's level of absolute risk aversion