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 8: The Phillips Curve: Recent Incarnations

Richard T. Froyen and Alfred V. Guender

Extract

INTRODUCTION The label “New Keynesian” suggests that the new framework features a nominal rigidity that is instrumental in propagating the effects of shocks to the economy. Because of the existence of this nominal rigidity, a change in the stance of monetary policy, too, leads to predictable changes in real output. But traditional Keynesian models and the New Keynesian framework differ on the exact nature of this nominal rigidity. Earlier Keynesian models emphasized the existence of sticky wage rates. New Keynesian models take a much more eclectic view of the sources of nominal rigidities in the economy. We begin here by considering New Keynesian models that feature sticky prices. These New Keynesian models assume that firms operate in a monopolistically competitive setting; they are price setters. In this environment firms find it costly to adjust prices because of the existence of menu cost or out of fear of harming customer relations. Alternatively, they may lack total control over setting prices and instead face an exogenous stochastic price adjustment process. Irrespective of the particular form of the price adjustment process in the New Keynesian framework, firms take a forwardlooking perspective when setting current prices. Firms look at the future because they realize that they may be unable to change their prices for a while. Thus expected future developments influence the setting of current prices. The existence of sticky prices and the forward-looking perspective adopted by firms give rise to a dynamic path for the aggregate price level. This path...

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