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On the Dynamic Consistency of Optimal Monetary Policy

  • R. Cellini
  • L. Lambertini

The literature on the time inconsistency of optimal monetary policy puts forward the idea that a central bank may strategically exploit the first mover advantage against the privat sector, manipulating expectations so as to achieve a higher level of employment and output. We argue that this view is largely ill-founded. We show that the dynamic version of the basic model used in the literature is an optimal control model yealding a time consistent and stable solution to the central banker’s problem, where prices are stable and the output reaches the full employment level in steady state. Then we extend it to include a strategic privat sector, which transforms the initial setup into a different game. We prove that such a game has a strongly time consistent open-loop Nash equilibrium, as well as a time consistent Stackelberg open-loop equilibrium with the bank leading,where, however, the bank cannot gain as compared to the simultaneous game. With the privat sector leading, inflation may arise in equilibrium if output is below the full employment level.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 463.

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Date of creation: 2003
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Handle: RePEc:bol:bodewp:463
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  1. Svensson, Lars E O, 1998. "Inflation Targeting as a Monetary Policy Rule," CEPR Discussion Papers 1998, C.E.P.R. Discussion Papers.
  2. Persson, Torsten & Tabellini, Guido, 1999. "Political economics and macroeconomic policy," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 22, pages 1397-1482 Elsevier.
  3. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Chang, Roberto, 1998. "Credible Monetary Policy in an Infinite Horizon Model: Recursive Approaches," Journal of Economic Theory, Elsevier, vol. 81(2), pages 431-461, August.
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  6. Persson, Mats & Persson, Torsten & Svensson, Lars E O, 1987. "Time Consistency of Fiscal and Monetary Policy," Econometrica, Econometric Society, vol. 55(6), pages 1419-31, November.
  7. Christian Schultz, 1996. "Announcements and Credibility of Monetary Policy," Discussion Papers 96-07, University of Copenhagen. Department of Economics.
  8. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
  9. Alesina, Alberto & Tabellini, Guido, 1987. "Rules and Discretion with Noncoordinated Monetary and Fiscal Policies," Economic Inquiry, Western Economic Association International, vol. 25(4), pages 619-30, October.
  10. Xie, Danyang, 1997. "On Time Inconsistency: A Technical Issue in Stackelberg Differential Games," Journal of Economic Theory, Elsevier, vol. 76(2), pages 412-430, October.
  11. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November.
  12. Turnovsky, Stephen J. & Brock, William A., 1980. "Time consistency and optimal government policies in perfect foresight equilibrium," Journal of Public Economics, Elsevier, vol. 13(2), pages 183-212, April.
  13. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  14. Alan S. Blinder, 2000. "Central-Bank Credibility: Why Do We Care? How Do We Build It?," American Economic Review, American Economic Association, vol. 90(5), pages 1421-1431, December.
  15. Kydland, Finn, 1977. "Equilibrium solutions in dynamic dominant-player models," Journal of Economic Theory, Elsevier, vol. 15(2), pages 307-324, August.
  16. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  17. Kydland, Finn, 1975. "Noncooperative and Dominant Player Solutions in Discrete Dynamic Games," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 16(2), pages 321-35, June.
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