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The Making of Optimal and Consistent Policy: An Implementation Theory Framework for Monetary Policy

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Author Info

  • Huiping Yuan

    ()
    (Department of Finance, Xiamen University)

  • Stephen M. Miller

    ()
    (Department of Economics, University of Nevada, Las Vegas)

Abstract

This paper shows that optimal policy and consistent policy outcomes require the use of control-theory and game-theory solution techniques. While optimal policy and consistent policy often produce different outcomes even in a one-period model, we analyze consistent policy and its outcome in a simple model, finding that the cause of the inconsistency with optimal policy traces to inconsistent targets in the social loss function. As a result, the social loss function cannot serve as a direct loss function for the central bank. Accordingly, we employ implementation theory to design a central bank loss function (mechanism design) with consistent targets, while the social loss function serves as a social welfare criterion. That is, with the correct mechanism design for the central bank loss function, optimal policy and consistent policy become identical. In other words, optimal policy proves implementable (consistent).

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File URL: http://web.unlv.edu/projects/RePEc/pdf/0910.pdf
File Function: First version, 2008
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Bibliographic Info

Paper provided by University of Nevada, Las Vegas , Department of Economics in its series Working Papers with number 0910.

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Length: 29 pages
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:nlv:wpaper:0910

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Keywords: Optimal policy; Consistent policy; Implementation theory;

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References

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  1. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
  2. Svensson, L.E.O., 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," Papers 595, Stockholm - International Economic Studies.
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  8. Pollak, Robert A, 1979. "Bergson-Samuelson Social Welfare Functions and the Theory of Social Choice," The Quarterly Journal of Economics, MIT Press, vol. 93(1), pages 73-90, February.
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  11. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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  13. Kydland, Finn, 1977. "Equilibrium solutions in dynamic dominant-player models," Journal of Economic Theory, Elsevier, vol. 15(2), pages 307-324, August.
  14. Huiping Yuan & Stephen M. Miller & Langnan Chen, 2006. "The Making of Optimal and Consistent Policy: An Analytical Framework for Monetary Models," Working papers 2006-05, University of Connecticut, Department of Economics, revised Jan 2009.
  15. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  16. Matthew O. Jackson, 2001. "A crash course in implementation theory," Social Choice and Welfare, Springer, vol. 18(4), pages 655-708.
  17. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  18. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  19. Huiping Yuan & Stephen M. Miller & Langnan Chen, 2009. "The Optimality and Controllability of Monetary Policy through Delegation with Consistent Targets," Working Papers 0909, University of Nevada, Las Vegas , Department of Economics.
  20. 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.
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  24. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  25. Calvo, Guillermo A, 1978. "Some Notes on Time Inconsistency and Rawls' Maximin Criterion," Review of Economic Studies, Wiley Blackwell, vol. 45(1), pages 97-102, February.
  26. V.V. Chari, 1988. "Time consistency and optimal policy design," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 17-31.
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Cited by:
  1. Huiping Yuan & Stephen M. Miller & Langnan Chen, 2011. "The Optimality And Controllability Of Monetary Policy Through Delegation With Consistent Targets," Scottish Journal of Political Economy, Scottish Economic Society, vol. 58(1), pages 82-106, February.

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