Optimal monetary policy design for an imperfect economy

Purpose: The questions that we address in this paper are the following. In the context of the particular DSGE model with labour market frictions, do animal spirits expectations and rational expectations yield qualitatively and quantitatively different outcomes in the face of supply and demand shocks? Does the optimal monetary policy response differ for the two types of expectation? Does there exist a simple rule such as the Taylor rule that can replicate the outcomes for all variables obtained when monetary policy is set optimally? How do these replicating values depend on the degree of the labour market and expectations imperfections? Under what circumstances should the central bank be targeting inflation and/or economic activity? Should it smooth its interest rate responses? Findings: We find qualitatively different outcomes for an 'animal spirits' expectations heuristic to rational expectations after supply and demand shocks. Provided monetary policy is optimally set, major differences arise only for supply shocks. A Taylor rule can replicate optimal monetary policy outcomes regardless of the degree of imperfections under demand shocks, however this is not true under supply shocks. We argue that the persistence of the interest rate typically found in practice is optimal in the presence of supply shocks, since demand shocks can be perfectly accomodated by changing the interest rate immediately.