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How Important Is Precommitment for Monetary Policy?

  • Dennis, Richard

    ()

    (Federal Reserve Bank of San Francisco)

  • Söderström, Ulf

    ()

    (Research Department, Central Bank of Sweden)

Economic outcomes in dynamic economies with forward-looking agents depend crucially on whether or not the central bank can precommit, even in the absence of the traditional "inflation bias." This paper quantifies the welfare differential between precommitment and discretionary policy in both a stylized theoretical framework and in estimated data-consistent models. From the precommitment and discretionary solutions we calculate the permanent deviation of inflation from target that in welfare terms is equivalent to moving from discretion to precommitment, the "inflation equivalent." In the estimated models, using a range of reasonable central bank preference parameters, the "inflation equivalent" ranges from 0.05 to 3.6 percentage points, with a mid-point of either 0.15 or 1–1.5 percentage points, depending on the model. In addition to the degree of forward-looking behavior, we show that the existence of transmission lags and/or information lags is crucial for determining the welfare gain from precommitment.

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Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 139.

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Length: 37 pages
Date of creation: 01 Sep 2002
Date of revision:
Publication status: Forthcoming in Journal of Money, Credit, and Banking.
Handle: RePEc:hhs:rbnkwp:0139
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Sveriges Riksbank, SE-103 37 Stockholm, Sweden

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Web page: http://www.riksbank.com/
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