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 12: The New Keynesian Model: The Backward-Looking Case

Richard T. Froyen and Alfred V. Guender

Extract

In Chapter 9, we analyzed optimal monetary policy in a forward-looking version of the New Keynesian model. That model has the advantage of being built on solid microeconomic foundations. Important features of the forward-looking model are that a. expectations about the future rate of inflation and output gap affect their current levels. b. a change in monetary policy, brought about by an increase in the real rate of interest, has a contemporaneous effect on both real output and the rate of inflation. c. there is no persistence in the rate of inflation or real output in the structural relations. The forward-looking model is, however, not immune to criticism. Critics point out that the forward-looking Phillips Curve in particular suffers from a number of undesirable features. In Chapter 8, we showed that the forwardlooking Phillips Curve is not consistent with the natural rate hypothesis. One might argue further that the forward-looking Phillips Curve gives rise to at least one implausible and counterintuitive prediction: a tightening in monetary policy that results in a negative output gap leads to a rise in expected inflation.1 Disinflation will also set in without delay if the central bank can directly affect the current expectation of future inflation. As a rule, however, disinflation occurs gradually and involves substantial costs in terms of lost output. The purpose of this chapter is to show how the optimal policy rule, the reaction function underlying it, and the time series...

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