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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 (Xiamen University)
Stephen M. Miller (University of Connecticut and University of Nevada, Las Vegas)

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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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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2006-06.

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Length: 30 pages
Date of creation: Feb 2006
Date of revision: Jan 2009
Handle: RePEc:uct:uconnp:2006-06

Note: We presented an earlier version at Federal Reserve Bank of Boston.
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Find related papers by JEL classification:
E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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    Other versions:
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  1. 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. [Downloadable!]
    Other versions:
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