9. The forward-looking model: the closed economy In this chapter we present the building blocks of the forward-looking model. We proceed to show how the policymaker goes about choosing real output and the rate of inﬂation from the perspective of optimal monetary policy. The policy choices that materialize under optimal policy under commitment are then compared to those that occur under discretionary policymaking. In addition, we present two monetary policy strategies that are special cases of the optimal policy rule. Both special cases are referred to as eﬃcient monetary policy strategies in the literature. Finally, we examine the issue of target versus instrument rules in the conduct of monetary policy. THE MODEL, THE POLICYMAKER’S OBJECTIVES AND INFORMATION SET The characterizing feature of the forward-looking model is that its building blocks are grounded in the optimizing behavior of households and price-setting ﬁrms in a rational-expectations framework. The previous chapter discusses several ways in which optimizing behavior on the part of forward-looking, monopolistically competitive ﬁrms leads to the existence of sticky prices in the economy. Either ﬁrms ﬁnd it costly to adjust prices (Rotemberg, 1982), or ﬁrms can change the price of their product only at random intervals (Calvo, 1983). Sticky prices are thus not simply assumed, as was the case in earlier Keynesian models, but result from the existence of menu cost or stochastic price adjustment. A third way of generating sticky prices is to introduce staggered wage contracts and let the aggregate price level be linked to current...
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