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Optimal policy with limited commitment

  • Kenneth Kasa

This paper uses Whiteman's(1986) frequency-domain optimization methodology to parameterize the precommitment period in a standard rational expectations policy design model. This allows researchers to adopt an empirical approach to the time consistency issue. That is, the operative commitment horizon in a given policy setting can be estimated along with the other parameters characterizing the preferences and constraints of the agents in the model. It is shown that the commitment horizon can be estimated by running (restricted) regressions of the policymaker's instrument variable on past values of its target variable. ; Parameterizing the commitment horizon also delivers a mapping between welfare (or the value of the policymaker's objective function) and the length of the commitment horizon. The paper shows that the rate of convergence to the perfect precommitment value can be either quite slow or quite rapid, suggesting that the severity of the time consistency constraint can be sensitive to variation in the assumed commitment horizon. ; Finally, the results are applied to U.S. and German monetary policy during the post-Bretton Woods era. Assuming the monetary authority attempts to stabilize inflation using a Federal Funds like interest rate as an instrument, the results point to a one-month ahead commitment horizon for the U.S. Federal Reserve, and to a twelve-month ahead commitment horizon for the German Bundesbank. However, these horizons are estimated very imprecisely.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 94-16.

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Date of creation: 1994
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Handle: RePEc:fip:fedfap:94-16
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  1. Hansen, Lars Peter & Sargent, Thomas J., 1980. "Formulating and estimating dynamic linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 7-46, May.
  2. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1986. "Optimal cartel equilibria with imperfect monitoring," Journal of Economic Theory, Elsevier, vol. 39(1), pages 251-269, June.
  3. Reinganum, Jennifer F & Stokey, Nancy L, 1985. "Oligopoly Extraction of a Common Property Natural Resource: The Importance of the Period of Commitment in Dynamic Games," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(1), pages 161-73, February.
  4. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  5. Sargent, Thomas J, 1984. "Autoregressions, Expectations, and Advice," American Economic Review, American Economic Association, vol. 74(2), pages 408-15, May.
  6. 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.
  7. Roberto Chang, 1996. "Credible monetary policy with long-lived agents: recursive approaches," Working Paper 96-20, Federal Reserve Bank of Atlanta.
  8. Whiteman, Charles H, 1986. "An Analytical Policy Design under Rational Expectations," Econometrica, Econometric Society, vol. 54(6), pages 1387-1405, November.
  9. Taub, Bart, 1986. "Asymptotic Properties of Pipeline Control of the Money Supply," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 27(3), pages 647-65, October.
  10. Christiano, Lawrence J., 1985. "A method for estimating the timing interval in a linear econometric model, with an application to Taylor's model of staggered contracts," Journal of Economic Dynamics and Control, Elsevier, vol. 9(4), pages 363-404, December.
  11. William Roberds, 1986. "Models of policy under stochastic replanning," Staff Report 104, Federal Reserve Bank of Minneapolis.
  12. 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.
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