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Monetary Policy under Imperfect Commitment : Reconciling Theory with Evidence

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  • Hakan Kara

Abstract

In the standard forward-looking models of the recent literature, theoretical optimal monetary policy rules imply much higher inertia of interest rates than estimated historical policy rules. Motivated by the observation that theoretical policy rules often assume perfect commitment on the part of the monetary authority, this study formulates the monetary policy behavior with a continuum from discretion to full commitment and, using this setup, seeks to match the theory with evidence. It is shown that optimal instrument rules under imperfect commitment exhibit less inertia on the policy instrument; the degree of inertia declines as the policy moves from full commitment to discretion. Therefore, under the assumption that the monetary authorities operate somewhere in between discretion and commitment, historically observed policy behavior can be reconciled with the optimal policy rules - even in a purely forward-looking framework. As a by-product, we propose a method to measure the stance of monetary policy from the perspective of discretion versus commitment. To test our proposal, we estimate a structural monetary policy rule for the Federal Reserve, which nests discretion and commitment as special cases. Empirical results suggest that recent practice of monetary policy has been closer to commitment than the policy pursued in the 1970s.

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Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 0415.

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Date of creation: 2004
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Handle: RePEc:tcb:wpaper:0415

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  1. Ernst Schaumburg & Andrea Tambalotti, 2003. "An investigation of the gains from commitment in monetary policy," Staff Reports, Federal Reserve Bank of New York 171, Federal Reserve Bank of New York.
  2. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers, C.V. Starr Center for Applied Economics, New York University 98-01, C.V. Starr Center for Applied Economics, New York University.
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2139, C.E.P.R. Discussion Papers.
  4. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 1(1), pages 19-46, January.
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  7. Favero, Carlo A & Rovelli, Riccardo, 2003. " Macroeconomic Stability and the Preferences of the Fed: A Formal Analysis, 1961-98," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 35(4), pages 545-56, August.
  8. Roberds, William, 1987. "Models of Policy under Stochastic Replanning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 731-55, October.
  9. Glenn D. Rudebusch, 2001. "Is The Fed Too Timid? Monetary Policy In An Uncertain World," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 203-217, May.
  10. Cecchetti, Stephen G & McConnell, Margaret M & Perez-Quiros, Gabriel, 2002. "Policymakers' Revealed Preferences and the Output-Inflation Variability Trade-Off: Implications for the European System of Central Banks," Manchester School, University of Manchester, University of Manchester, vol. 70(4), pages 596-618, Special I.
  11. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, Elsevier, vol. 52(1-2), pages 205-228.
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  13. Marc Paolo Giannoni & Michael Woodford, 2003. "How forward-looking is optimal monetary policy?," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 1425-1483.
  14. A. Hakan Kara, 2003. "Optimal Monetary Policy, Commitment, and Imperfect Credibility," Working Papers, Research and Monetary Policy Department, Central Bank of the Republic of Turkey 0301, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  15. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, pages 277-316.
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  19. Ozlale, Umit, 2003. "Price stability vs. output stability: tales of federal reserve administrations," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 27(9), pages 1595-1610, July.
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Cited by:
  1. Dreher, Axel & Moser, Christoph, 2008. "Do Markets Care About Central Bank Governor Changes? Evidence from Emerging Markets," Proceedings of the German Development Economics Conference, Zurich 2008, Verein für Socialpolitik, Research Committee Development Economics 29, Verein für Socialpolitik, Research Committee Development Economics.
  2. Schaumburg, Ernst & Tambalotti, Andrea, 2007. "An investigation of the gains from commitment in monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(2), pages 302-324, March.
  3. Kenneth Kuttner & Adam Posen, 2007. "Do Markets Care Who Chairs the Central Bank?," Department of Economics Working Papers, Department of Economics, Williams College 2007-05, Department of Economics, Williams College.
  4. Gerberding, Christina & Seitz, Franz & Worms, Andreas, 2007. "Money-based interest rate rules: lessons from German data," Discussion Paper Series 1: Economic Studies, Deutsche Bundesbank, Research Centre 2007,06, Deutsche Bundesbank, Research Centre.
  5. Efrem Castelnuovo, 2006. "Tracking U.S. Inflation Expectations with Domestic and Global Indicators," "Marco Fanno" Working Papers, Dipartimento di Scienze Economiche "Marco Fanno" 0031, Dipartimento di Scienze Economiche "Marco Fanno".

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