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Optimal Monetary Policy, Commitment, and Imperfect Credibility

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  • A. Hakan Kara

Abstract

In the conventional optimal monetary policy framework, two key assumptions underline the full commitment solution : Monetary authority is perfectly credible, and can commit for an infinite number of periods. Using a baseline forward-looking model, this study explores the implications of relaxing these assumptions in turn. First, finite lasting commitments are introduced using a stochastic exogenous process that generates policy reoptimizations. As a consequence, monetary policy is characterized with a continuum from pure discretion to full commitment. Second, we solve the optimal and robust targeting rules when the central bank confronts imperfect and/or uncertain credibility. Imperfect credibility is defined as a situation in which the private sector expects the commitment regime to end sooner than that is intended by the policy maker. The results indicate that, under imperfect credibility, optimal policy becomes observationally closer to the discretionary solution, the more being so as the degree of uncertainty rises. These findings may be insightful for explaining the observed near-discretionary behavior of the central banks, which indeed operate under imperfect credibility.

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Bibliographic Info

Article provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its journal Central Bank Review.

Volume (Year): 4 (2004)
Issue (Month): 1 ()
Pages: 31-66

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Handle: RePEc:tcb:cebare:v:4:y:2004:i:1:p:31-66

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Keywords: Optimal Monetary Policy; Stabilization Bias; Imperfect Credibility; Discretion; Commitment;

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Cited by:
  1. Hakan Kara, 2004. "Monetary Policy under Imperfect Commitment : Reconciling Theory with Evidence," Working Papers 0415, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  2. Glenn D. Rudebusch, 2006. "Monetary Policy Inertia: Fact or Fiction?," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 2(4), December.
  3. Troy Davig & Jeffrey R. Gerlach, 2006. "State-Dependent Stock Market Reactions to Monetary Policy," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 2(4), December.
  4. Tokhir Mirzoev, 2004. "Limited Commitment, Inaction and Optimal Monetary Policy," Macroeconomics, EconWPA 0409027, EconWPA.

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