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Using a projection method to analyze inflation bias in a micro-founded model

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  • Gary S. Anderson
  • Jinill Kim
  • Tack Yun

Abstract

Since Kydland and Prescott (1977) and Barro and Gordon (1983), most studies of the problem of the inflation bias associated with discretionary monetary policy have assumed a quadratic loss function. We depart from the conventional linear-quadratic approach to the problem in favor of a projection method approach. We investigate the size of the inflation bias that arises in a microfounded nonlinear environment with Calvo price setting. The inflation bias is found to lie between 1% and 6% for a reasonable range of parameter values, when the bias is defined as the steady-state deviation of the discretionary inflation rate from the optimal inflation rate under commitment.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2010-18.

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Date of creation: 2010
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Handle: RePEc:fip:fedgfe:2010-18

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Keywords: Inflation (Finance) ; Econometric models;

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References

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  1. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal taxation in an RBC model: A linear-quadratic approach," Discussion Papers 0405-16, Columbia University, Department of Economics.
  2. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  3. Paul Klein & Per Krusell & José-V�ctor R�os-Rull, 2008. "Time-Consistent Public Policy," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 789-808.
  4. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April.
  5. Ernst Schaumburg & Andrea Tambalotti, 2003. "An investigation of the gains from commitment in monetary policy," Staff Reports 171, Federal Reserve Bank of New York.
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2010. "The Optimal Rate of Inflation," NBER Working Papers 16054, National Bureau of Economic Research, Inc.
  7. Viktor Winschel & Markus Krätzig, 2008. "JBendge: An Object-Oriented System for Solving, Estimating and Selecting Nonlinear Dynamic Models," SFB 649 Discussion Papers SFB649DP2008-034, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  8. Ulf Söderström & Paul Söderlind & Anders Vredin, 2005. "New-Keynesian Models and Monetary Policy: A Re-examination of the Stylized Facts," Scandinavian Journal of Economics, Wiley Blackwell, vol. 107(3), pages 521-546, 09.
  9. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
  10. Robert G. King & Alexander L. Wolman, 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," International Finance Discussion Papers 802, Board of Governors of the Federal Reserve System (U.S.).
  11. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  12. Davide Debortoli & Ricardo Nunes, 2007. "Loose commitment," International Finance Discussion Papers 916, Board of Governors of the Federal Reserve System (U.S.).
  13. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  14. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
  15. Gapen Michael T. & Cosimano Thomas F., 2005. "Solving Ramsey Problems with Nonlinear Projection Methods," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 9(2), pages 1-38, June.
  16. Anderson, Gary S. & Kim, Jinill & Yun, Tack, 2010. "Using a projection method to analyze inflation bias in a micro-founded model," Journal of Economic Dynamics and Control, Elsevier, vol. 34(9), pages 1572-1581, September.
  17. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  18. Willem Van Zandweghe & Alexander L. Wolman, 2010. "Discretionary monetary policy in the Calvo model," Research Working Paper RWP 10-06, Federal Reserve Bank of Kansas City.
  19. King, Mervyn, 1997. "Changes in UK monetary policy: Rules and discretion in practice," Journal of Monetary Economics, Elsevier, vol. 39(1), pages 81-97, June.
  20. Dotsey, Michael & Hornstein, Andreas, 2003. "Should a monetary policymaker look at money?," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 547-579, April.
  21. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  22. Tack Yun, 2005. "Optimal Monetary Policy with Relative Price Distortions," American Economic Review, American Economic Association, vol. 95(1), pages 89-109, March.
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Cited by:
  1. Gary S. Anderson & Jinill Kim & Tack Yun, 2010. "Using a projection method to analyze inflation bias in a micro-founded model," Finance and Economics Discussion Series 2010-18, Board of Governors of the Federal Reserve System (U.S.).

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