Optimal Monetary Policy under Uncertainty

Optimal Monetary Policy under Uncertainty

Richard T. Froyen and Alfred V. Guender

Recently there has been a resurgence of interest in the study of optimal monetary policy under uncertainty. This book provides a thorough survey of the literature that has resulted from this renewed interest. The authors ground recent contributions on the ‘science of monetary policy’ in the literature of the 1970s, which viewed optimal monetary policy as primarily a question of the best use of information, and studies in the 1980s that gave primacy to time inconsistency problems. This broad focus leads to a better understanding of current issues such as discretion versus commitment, target versus instrument rules, and the merits of delegation of policy authority.

Chapter 4: A Variable Price Level, Supply Shocks and Rational Expectations

Richard T. Froyen and Alfred V. Guender

Extract

The analysis in Chapters 2 and 3 was carried out with a constant price level. Implicitly we assumed that the aggregate supply schedule was a fixed horizontal line. Whatever level of output was demanded was supplied at the given price level. The focus was on the determination of aggregate demand. In this chapter we include an explicit aggregate supply schedule and allow for a variable price level. Once we allow for a variable price level we must take into account the expectations of economic agents concerning the price level. We also want to allow for shifts in the aggregate supply schedule – so-called supply shocks. After setting out the variable price model in the first section, we reexamine the instrument problem considered in Chapters 2 and 3. We go on in the third section to examine optimal combination policies. Finally, in the last two sections we analyze the role that lagged feedback rules can play in monetary policy. THE VARIABLE PRICE MODEL The analysis is carried out within the model specified in the first section of Chapter 2. yt ϭ c0 ϩ c1 (pt Ϫ pe tϪ1 ) ϩ ut, t, yt ϭ where yt pt rt Mt e ptϩj,tϪi ϭ real output, ϭ aggregate price level, ϭ nominal interest rate, ϭ nominal money supply, ϭ expectation of the aggregate price level for period (tϩj) formed on the basis of information at (tϪi), 2 2 ut, vt, ␩t ϭ white noise disturbance terms with variances ␴2, ␴v and ␴␩, u a0 Ϫ a1 (rt Ϫ (pe tϪ1 Ϫ t...

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