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The pitfalls of discretionary monetary policy

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  • Aubhik Khan
  • Robert G. King
  • Alexander L. Wolman

Abstract

In a canonical staggered pricing model, monetary discretion leads to multiple private sector equilibria. The basis for multiplicity is a form of policy complementarity. Specifically, prices set in the current period embed expectations about future policy, and actual future policy responds to these same prices. For a range of values of the fundamental state variable — a ratio of predetermined prices — there is complementarity between actual and expected policy, and multiple equilibria occur. Moreover, this multiplicity is not associated with reputational considerations: it occurs in a two-period model.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 01-16.

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Date of creation: 2001
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Handle: RePEc:fip:fedpwp:01-16

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Keywords: Monetary policy;

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References

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  1. V.V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectation traps and discretion," Working Paper Series, Macroeconomic Issues WP-96-5, Federal Reserve Bank of Chicago.
  2. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
  3. Currie,David & Levine,Paul, 2009. "Rules, Reputation and Macroeconomic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521104609, April.
  4. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Sticky price models of the business cycle: can the contract multiplier solve the persistence problem?," Staff Report 217, Federal Reserve Bank of Minneapolis.
  5. Robert King & Alexander L. Wolman, 1999. "What Should the Monetary Authority Do When Prices Are Sticky?," NBER Chapters, in: Monetary Policy Rules, pages 349-404 National Bureau of Economic Research, Inc.
  6. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 825-860, October.
  7. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
  8. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November.
  9. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  10. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 743-764.
  11. Krusell, Per & Smith Jr., Anthony A, 2001. "Consumption-Savings Decisions with Quasi-Geometric Discounting," CEPR Discussion Papers 2651, C.E.P.R. Discussion Papers.
  12. 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.
  13. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
  14. 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.
  15. Huberto Ennis & Todd Keister, 2001. "Optimal policy with probabilistic equilibrium selection," Working Paper 01-03, Federal Reserve Bank of Richmond.
  16. Alexander L. Wolman, 1999. "Sticky prices, marginal cost, and the behavior of inflation," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 29-48.
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Cited by:
  1. David M. Arseneau, 2004. "Expectation traps in a New Keynesian open economy model," Finance and Economics Discussion Series 2004-45, Board of Governors of the Federal Reserve System (U.S.).
  2. Willem Van Zandweghe & Alexander Wolman, 2011. "Discretionary monetary policy in the Calvo model," Working Paper 11-03, Federal Reserve Bank of Richmond.

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