Optimal Monetary Policy under Uncertainty
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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.
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Chapter 9: The Forward-Looking Model: The Closed Economy

Richard T. Froyen and Alfred V. Guender


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 wages by a constant mark-up factor (Taylor,...

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