Optimal sustainable monetary policy

In recent monetary policy literature, optimal commitment policy and its variant from a timeless perspective have been studied with emphasis on welfare gains from policy commitment. These policies, however, involve a time-consistency problem called a stabilization bias in forward-looking models. We analyze Chari and Kehoe's [1990. Sustainable plans. Journal of Political Economy 98, 783-802] sustainable equilibrium and examine optimal sustainable policy, i.e. a policymaker's strategy in the best sustainable equilibrium. This paper shows that such a policy becomes consistent with the optimal commitment policy in sufficiently later periods. It also shows that whether the optimal sustainable policy can attain the Ramsey equilibrium outcome depends on the magnitude of shocks hitting the model economy. Moreover, the paper finds a sustainable policy that attains higher social welfare than discretionary policy does.     

Discretionary monetary policy and the zero lower bound on nominal interest rates

Ignoring the existence of the zero lower bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.     

Inflation Targeting as Constrained Discretion

This paper suggests a simple framework for modeling inflation targeting as constrained discretion. Although it is widely claimed that inflation targeting has been successful in maintaining low and stable inflation, an announcement of an inflation target does not by itself mean that central bankers are precommiting to how they conduct monetary policy. In comparison to the assumption of many theoretical studies, central banks conduct monetary policy in a discretionary fashion and rarely precommit to a rule in reality. Therefore, the central bank in this paper is modeled as discretionary, yet faced with a constraint, that an average of future inflation over a certain horizon should be kept on or near the preannounced target level. It is natural to add this constraint to the central banker’s optimization problem, since inflation targeting involves one way or another an evaluation of the performance over a certain horizon. So it is argued that the better outcome of inflation targeting does not come from a commitment but from “constrained discretion.” This paper also sheds some light on optimal targeting horizon.     

Monetary Policy in a Forward-Looking Input–Output Economy

This paper examines the implications for monetary policy of sticky prices in both final and intermediate goods in a New Keynesian model. Both optimal policy under commitment and discretionary policy under simple loss functions are studied. Household utility losses under alternative loss functions are compared; additionally, the robustness of policy performance to model and shock misperceptions and parameter uncertainty is examined. Targeting inflation in both consumer and intermediate goods performs better than targeting inflation in one sector; targeting price levels of both final and intermediate goods performs significantly better. Moreover, targeting price levels in both sectors yields superior robustness properties.     

Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates

I characterize optimal monetary and fiscal policy in a stochastic New Keynesian model when nominal interest rates may occasionally hit the zero lower bound. The benevolent policymaker controls the short‐term nominal interest rate and the level of government spending. Under discretionary policy, accounting for fiscal stabilization policy eliminates to a large extent the welfare losses associated with the presence of the zero bound. Under commitment, the gains associated with the use of the fiscal policy tool remain modest, even though fiscal stabilization policy is part of the optimal policy mix.     

Simple versus optimal rules as guides to policy

This paper compares the performance of different policy rules. Our comparisons focus on simple feedback rules versus rules which are optimal, given knowledge of the correct economic structure and the appropriate loss function for the policymaker. First, we compare rule performance when the correct model is not known. Second, we compare rule performance with respect to the frequency-specific behavior for variables of interest. Taken as a whole, our results indicate how the case for a model-specific optimal rule can break down when one relaxes the assumption that the true model is known as well as the assumption that the appropriate loss function is known. Links are made to the literature on monetary policy.     

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady‐state debt to follow a random walk. In this paper we consider the nature of the time inconsistency involved in such a policy and its implication for discretionary policymaking. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady‐state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government's objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi‐commitment policy, which allows for different probabilities of reneging on past promises.     

Model Uncertainty and Delegation: A Case for Friedman's k-Percent Money Growth Rule?

Model uncertainty affects the monetary policy delegation problem. If there is uncertainty with regards to the determination of the delegated objective variables, the central bank will want robustness against potential model misspecifications. We show that with plausible degree of model uncertainty, delegation of the Friedman rule of increasing the money stock by k percent to the central bank will outperform commitment to the social loss function (flexible inflation targeting). The reason is that the price paid for robustness under flexible inflation targeting outweighs the inefficiency of money growth targeting. Imperfect control of money growth does not change this conclusion.     

What Is in a Name? Purchases and Sales of Financial Assets as a Monetary Policy Instrument

This paper studies optimal interest rate and balance sheet policy in a quantitative New Keynesian model with a constrained financial sector, considering commitment versus discretion in monetary policy design and fixing either instrument. Optimal interest rate policy under commitment (discretion) achieves 93.0% (82.6%) of the potential gains to dual instrument monetary policy under commitment. Optimal discretionary dual instrument policy eliminates the cost of commitment limitations and exhibits no inflationary bias. Under commitment, the optimal balance sheet policy eliminates the cost of suboptimal interest rate policy, for example, an interest rate peg. Finally, I compare optimal policies to implementable rules-based policies.     

An investigation of the gains from commitment in monetary policy

We propose a simple framework for analyzing a continuum of monetary policy rules characterized by differing degrees of credibility, in which commitment and discretion become special cases of what we call quasi-commitment. The monetary policy authority is assumed to formulate optimal commitment plans, to be tempted to renege on them, and to succumb to this temptation with a constant exogenous probability known to the private sector. By interpreting this probability as a continuous measure of the (lack of) credibility of the monetary policy authority, we investigate the welfare effect of a marginal increase in credibility. Our main finding is that, in a simple model of the monetary transmission mechanism, most of the gains from commitment accrue at relatively low levels of credibility.     

Coordinating Monetary and Macroprudential Policies

This paper studies noncooperative games between a monetary authority and a macroprudential regulator whose objectives are a subset of those in the social loss function. The analysis is based on a New Keynesian model with a financial sector and a financial friction à la Gertler and Karadi (2011). When the friction affects the financing of all factors of production equally, macroprudential policy is shown to be a powerful additional tool, fully eliminating inefficiencies, regardless of the source of the shock and no matter whether the central bank and the regulator cooperate. But when trade‐offs are present and policy is discretionary, the institutional arrangements become crucial. While coordination leads to higher welfare than a setting in which each authority takes the decision rule of the other as given (namely, the Nash equilibrium), our analysis shows that a noncooperative setting in which the macroprudential authority acts as a leader within the period can be superior to cooperation. Finally, our conclusions are unaffected by whether the macroprudential instrument affects funding costs or acts as a liquidity requirement.     

Information variables for monetary policy in an estimated structural model of the euro area

A small scale new keynesian model for the euro area is estimated with maximum likelihood under the assumptions of imperfect information and discretionary monetary policy. The estimated parametrization of this widely used dynamic stochastic model unveils the monetary authorities’ objectives and the information content of two indicator variables: monetary aggregates and real unit labour costs. The results highlight a significant policy concern about interest-rate smoothing and inflation; almost no concern for output gap stabilization emerges. Regarding indicator variables, unit labour costs provide information on potential output that is helpful for stabilization policy; no useful information role emerges for monetary aggregates.     

Managing Beliefs about Monetary Policy under Discretion

In models of monetary policy, discretionary policymaking is typically constrained in its ability to manage public beliefs. However, when a policymaker possesses private information, policy actions serve as signals to the public about unobserved economic conditions and belief management becomes an integral part of optimal discretion policies. This article derives the optimal time‐consistent policy for a general linear‐quadratic setting. The optimal policy is illustrated in a simple New Keynesian model, where analytical solutions can be derived as well. In this model, imperfect information about the policymaker's output target leads to lower policy losses.     

A general theory of controllability and expectations anchoring for small-open economies

Rational expectations are often used as an argument against policy activism, as they may undermine or neutralize the policymaker’s actions. Although this sometimes happens, rational expectations do not always imply policy invariance or ineffectiveness. In fact, in certain circumstances rational expectations can enhance our power to control an economy over time. In those cases, policy announcements can be used to extend the impact of conventional policy instruments. We present a general forward-looking policy framework and use it to provide a formal rationale for testing when policymakers can and cannot expect to be able to manage expectations. To describe the relevance of our results applications are shown for policy design in small-open economies. Those are the cases where domestic policies are at their weakest and our ability to influence expectations most constrained.     

Discretionary monetary policy and inflation persistence

Rational expectations models of staggered price/wage contracts have failed to replicate the observed persistence in inflation and unemployment during disinflationary periods. The current literature on this persistency puzzle has focused on augmenting the nominal contract model with imperfect credibility and learning. In this paper, I re-examine the persistency puzzle by focusing on the discretionary nature of monetary policy. I show that when the central bank is allowed to re-optimize a quadratic loss function each period, imperfect credibility and learning, even in the absence of staggered contracts, can generate a significant amount of inflation persistence and employment losses during a disinflationary period.     

Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson and Solow and Lucas

A policy maker knows two models. One implies an exploitable inflation-unemployment trade-off, the other does not. The policy maker's prior probability over the two models is part of his state vector. Bayes' law converts the prior probability into a posterior probability and gives the policy maker an incentive to experiment. For models calibrated to U.S. data through the early 1960s, we compare the outcomes from two Bellman equations. The first tells the policy maker to "experiment and learn." The second tells him to "learn but don't experiment." In this way, we isolate a component of government policy that is due to experimentation and estimate the benefits from intentional experimentation. We interpret the Bellman equation that learns but does not intentionally experiment as an "anticipated utility" model and study how well its outcomes approximate those from the "experiment and learn" Bellman equation. The approximation is good. For our calibrations, the benefits from purposeful experimentation are small because random shocks are big enough to provide ample unintentional experimentation.     

Phillips Curve Instability and Optimal Monetary Policy

Empirical evidence suggests the Phillips curve has flattened over the past few decades. To capture this feature of the data, I develop a framework where firms face a changing cost of price adjustment, which produces a Phillips curve with a slope coefficient that varies over time. To evaluate the implications for monetary policy, I construct the utility‐based welfare criterion where the relative weight on output gap deviations changes synchronously with the slope of the Phillips curve. The systematic component of the rule that implements optimal policy is constant under discretion and commitment.     

Identifying Discretionary Fiscal Policy Reactions with Real‐Time Data

We propose a method of identifying discretionary fiscal policy reactions using real‐time data. Automatic stabilizers should depend on true GDP, while discretionary fiscal policy is contingent on the information that policy makers have in real time. We can compute a real‐time measurement error by comparing the first release of GDP data with later revisions. Discretionary fiscal policy is influenced by this measurement error, whereas automatic fiscal policy is not. We use this identification approach to test the central identifying assumption of Blanchard and Perotti’s (2002) seminal structural vector autoregression (VAR). According to this assumption, fiscal policy makers do not react to GDP developments contemporaneously in a discretionary fashion. We find that government expenditure is adjusted upward if GDP growth in real time is lower than true GDP. This suggests that fiscal policy makers use short‐term funds to buy goods and services in response to their perception of GDP dynamics.     

The Cyclical Reaction of Fiscal Policies in the Euro Area: The Role of Modelling Choices and Data Vintages*

We survey the recent empirical literature concerning the cyclical response of fiscal policies in the euro area, finding large differences in results. We show that these differences are heavily influenced by the choices made in modelling fiscal behaviour. We make a case for the use, in assessing policies and in the EMU context, of the standard modelling choice where the discretionary reaction of fiscal policy is directly estimated. Models where the overall reaction to the cycle – which includes the effects of both discretionary actions and automatic stabilisers – is directly estimated tend to suggest either strong pro‐cyclical or strong counter‐cyclical discretionary reactions, depending on how this component is identified. Within the standard model and for the years 1994 to 2008, we show that results are significantly affected by the data vintage (ex post or real‐time). With ex post data, we find an unambiguous indication of a‐cyclicality. Using real‐time data, we find that the output gap matters. However, depending on whether we assess policy intentions or actual policies, euro‐area governments' behaviour radically changes. A plausible interpretation is that in the implementation phase, governments loosen their fiscal stance, giving in to political pressures that are proportional to the scale of the economic difficulties in bad times and the size of the ‘growth dividend’ in good times.     

The Determinants of the Volatility of Fiscal Policy Discretion

This paper investigates the determinants of the volatility of fiscal policy discretion. Using a linear dynamic panel data model for 113 countries from 1980 to 2006 and a system‐GMM estimator, we find that an increase in the number of episodes of government crisis, less democracy and presidentialist systems raise the volatility of the discretionary component of fiscal policy. Additionally, we show that countries with larger populations and less flexible exchange rate systems are more insured against uncertainty about the conduct of fiscal policy. Our results are robust to various regional dummy variables, different subsets of countries and the presence of high inflation and crisis episodes.