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On the implementation of Markov-perfect monetary policy

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  • Michael Dotsey
  • Andreas Hornstein

Abstract

The literature on optimal monetary policy in New Keynesian models under both commitment and discretion usually solves for the optimal allocations that are consistent with a rational expectations market equilibrium, but it does not study whether the policy can be implemented given the available policy instruments. Recently, King and Wolman (2004) have provided an example for which a time-consistent policy cannot be implemented through the control of nominal money balances. In particular, they find that equilibria are not unique under a money stock regime and they attribute the non-uniqueness to strategic complementarities in the price-setting process. The authors clarify how the choice of monetary policy instrument contributes to the emergence of strategic complementarities in the King and Wolman (2004) example. In particular, they show that for an alternative monetary policy instrument, namely, the nominal interest rate, there exists a unique Markov-perfect equilibrium. The authors also discuss how a time-consistent planner can implement the optimal allocation by simply announcing his policy rule in a decentralized setting.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-29.

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Date of creation: 2011
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Handle: RePEc:fip:fedpwp:11-29

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Keywords: Monetary policy ; Interest rates ; Money supply;

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References

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  1. Bernardino Adao & Isabel Correia & Pedro Teles, 2003. "Gaps and Triangles," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 699-713, October.
  2. Robert G. King & Alexander L. Wolman, 2004. "Monetary discretion, pricing complementarity, and dynamic multiple equilibria," Working Paper, Federal Reserve Bank of Richmond 04-05, Federal Reserve Bank of Richmond.
  3. Charles T. Carlstrom & Timothy S. Fuerst, 2001. "Timing and real indeterminacy in monetary models," Working Paper, Federal Reserve Bank of Cleveland 9910R, Federal Reserve Bank of Cleveland.
  4. Boyd Iii, J.H. & Dotsey, M., 1990. "Interest Rate Rules And Nominal Determinacy," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 222, University of Rochester - Center for Economic Research (RCER).
  5. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 83(2), pages 241-54, April.
  6. McCallum, Bennett T., 1983. "On non-uniqueness in rational expectations models : An attempt at perspective," Journal of Monetary Economics, Elsevier, Elsevier, vol. 11(2), pages 139-168.
  7. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "Price-level and interest-rate targeting in a model with sticky prices," Working Paper, Federal Reserve Bank of Cleveland 9819, Federal Reserve Bank of Cleveland.
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Cited by:
  1. Armenter, Roc, 2013. "The perils of nominal targets," Working Papers, Federal Reserve Bank of Philadelphia 14-2, Federal Reserve Bank of Philadelphia.

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