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On the implementation of Markov-perfect monetary policy

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  • Michael Dotsey
  • Andreas Hornstein

Abstract

The literature on optimal monetary policy in New Keynesian models under both commitment and discretion usually solves for the optimal allocations that are consistent with a rational expectations market equilibrium, but it does not study whether the policy can be implemented given the available policy instruments. Recently, King and Wolman (2004) have provided an example for which a time-consistent policy cannot be implemented through the control of nominal money balances. In particular, they find that equilibria are not unique under a money stock regime and they attribute the non-uniqueness to strategic complementarities in the price-setting process. The authors clarify how the choice of monetary policy instrument contributes to the emergence of strategic complementarities in the King and Wolman (2004) example. In particular, they show that for an alternative monetary policy instrument, namely, the nominal interest rate, there exists a unique Markov-perfect equilibrium. The authors also discuss how a time-consistent planner can implement the optimal allocation by simply announcing his policy rule in a decentralized setting.

Suggested Citation

  • Michael Dotsey & Andreas Hornstein, 2011. "On the implementation of Markov-perfect monetary policy," Working Papers 11-29, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:11-29
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    File URL: http://www.philadelphiafed.org/research-and-data/publications/working-papers/2011/wp11-29.pdf
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    References listed on IDEAS

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    1. Carlstrom, Charles T. & Fuerst, Timothy S., 2001. "Timing and real indeterminacy in monetary models," Journal of Monetary Economics, Elsevier, vol. 47(2), pages 285-298, April.
    2. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "Price-level and interest-rate targeting in a model with sticky prices," Working Paper 9819, Federal Reserve Bank of Cleveland.
    3. Bernardino Adão & Isabel Correia & Pedro Teles, 2003. "Gaps and Triangles," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 699-713.
    4. John H. Boyd & Michael Dotsey, 1990. "Interest rate rules and nominal determinacy," Working Paper 90-01, Federal Reserve Bank of Richmond.
    5. Robert G. King & Alexander L. Wolman, 2004. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 119(4), pages 1513-1553.
    6. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 343, European Central Bank.
    7. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-254, April.
    8. McCallum, Bennett T., 1983. "On non-uniqueness in rational expectations models : An attempt at perspective," Journal of Monetary Economics, Elsevier, vol. 11(2), pages 139-168.
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    Cited by:

    1. Armenter, Roc, 2013. "The perils of nominal targets," Working Papers 14-2, Federal Reserve Bank of Philadelphia, revised 04 Feb 2014.

    More about this item

    Keywords

    Monetary policy ; Interest rates ; Money supply;

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