Finance and Economics Discussion Series (FEDS)
A Promised Value Approach to Optimal Monetary Policy
Timothy S. Hills, Taisuke Nakata, and Takeki Sunakawa
This paper characterizes optimal commitment policy in the New Keynesian model using a novel recursive formulation of the central bank's infinite horizon optimization problem. In our recursive formulation motivated by Kydland and Prescott (1980), promised inflation and output gap--as opposed to lagged Lagrange multipliers--act as pseudo-state variables. Using three well known variants of the model--one featuring inflation bias, one featuring stabilization bias, and one featuring a lower bound constraint on nominal interest rates--we show that the proposed formulation sheds new light on the nature of the intertemporal trade-off facing the central bank.
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Keywords: Commitment, Inflation Bias, Optimal Policy, Ramsey Plans, Stabilization Bias, Zero Lower Bound
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