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Endogenous Monetary Policy in Macroeconomic Models: The Role of Commitment, Conservative Central Banker and Optimal Central Bank Contracts in the Credibility of Monetary Policy


  • Alajääskö, Pekka


This study focuses on the motives and constraints of the monetary policy authorities, i.e. the central banks. The fundamental theme is that the policy variable (inflation) is endogenous in the analysis. The behavior of this variable is a consequence of strategic and informational interactions between policymakers and private sector individuals and institutions. It is our aim to integrate old and new contributions of endogenous monetary policy models in a common framework. We will show how in the optimal central bank contract a linear cost of inflation is added to the central bank's loss function. This type of a contract is a perfect substitute for commitments. It enables the policymaker to precommit policy; it makes her policy announcement credible. We will also show that participation in a monetary union is beneficial for an inflation prone country with relatively small output variation. In that case expected gains from less inflation outweigh expected costs from less stabilization the monetary union is assumed to provide. In addition, it will be shown that the bigger the output variation of a country when the country's output is negatively correlated with the monetary union output, the more conservative (more weight on inflation than output stabilization) a central bank governor should be nominated in the country. This is because the more negative the output correlation is, the less weight the country prefers the monetary union to put on output stabilization. Each member country of the Economic and Monetary Union (EMU) can affect the monetary policy pursued by the EMU through its central bank governor.

Suggested Citation

  • Alajääskö, Pekka, 1996. "Endogenous Monetary Policy in Macroeconomic Models: The Role of Commitment, Conservative Central Banker and Optimal Central Bank Contracts in the Credibility of Monetary Policy," Research Reports 36, VATT Institute for Economic Research.
  • Handle: RePEc:fer:resrep:36

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    References listed on IDEAS

    1. Michael Lechner, 2002. "Program Heterogeneity And Propensity Score Matching: An Application To The Evaluation Of Active Labor Market Policies," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 205-220, May.
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    3. Aki Kangasharju, 2007. "Do Wage Subsidies Increase Employment in Subsidized Firms?," Economica, London School of Economics and Political Science, vol. 74(293), pages 51-67, February.
    4. Jochen Kluve & Hartmut Lehmann & Christoph M. Schmidt, 2000. "Disentangling Treatment Effects of Polish Active Labour Market Policies: Evidence from Matched Samples," CERT Discussion Papers 0007, Centre for Economic Reform and Transformation, Heriot Watt University.
    5. Petra E. Todd & Jeffrey A. Smith, 2001. "Reconciling Conflicting Evidence on the Performance of Propensity-Score Matching Methods," American Economic Review, American Economic Association, vol. 91(2), pages 112-118, May.
    6. Rajeev H. Dehejia & Sadek Wahba, 1998. "Causal Effects in Non-Experimental Studies: Re-Evaluating the Evaluation of Training Programs," NBER Working Papers 6586, National Bureau of Economic Research, Inc.
    7. Rajeev H. Dehejia & Sadek Wahba, 2002. "Propensity Score-Matching Methods For Nonexperimental Causal Studies," The Review of Economics and Statistics, MIT Press, vol. 84(1), pages 151-161, February.
    8. Czarnitzki, Dirk & Fier, Andreas, 2002. "Do Innovation Subsidies Crowd Out Private Investment? Evidence from the German Service Sector," ZEW Discussion Papers 02-04, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
    9. Venetoklis, Takis & Kangasharju, Aki, 2002. "Business Subsidies and Employment of Firms: Overall Evaluation and Regional Extension," Discussion Papers 268, VATT Institute for Economic Research.
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