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The Making of Optimal and Consistent Policy: An Implementation Theory Framework for Monetary Policy

  • Huiping Yuan


    (Department of Finance, Xiamen University)

  • Stephen M. Miller


    (Department of Economics, University of Nevada, Las Vegas)

This paper shows that optimal policy and consistent policy outcomes require the use of control-theory and game-theory solution techniques. While optimal policy and consistent policy often produce different outcomes even in a one-period model, we analyze consistent policy and its outcome in a simple model, finding that the cause of the inconsistency with optimal policy traces to inconsistent targets in the social loss function. As a result, the social loss function cannot serve as a direct loss function for the central bank. Accordingly, we employ implementation theory to design a central bank loss function (mechanism design) with consistent targets, while the social loss function serves as a social welfare criterion. That is, with the correct mechanism design for the central bank loss function, optimal policy and consistent policy become identical. In other words, optimal policy proves implementable (consistent).

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Paper provided by University of Nevada, Las Vegas , Department of Economics in its series Working Papers with number 0910.

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Length: 29 pages
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:nlv:wpaper:0910
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  7. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  8. Svensson, Lars E O, 1997. "Optimal Inflation Targets, "Conservative" Central Banks, and Linear Inflation Contracts," American Economic Review, American Economic Association, vol. 87(1), pages 98-114, March.
  9. Matthew O. Jackson, 2001. "A crash course in implementation theory," Social Choice and Welfare, Springer, vol. 18(4), pages 655-708.
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  12. Huiping Yuan & Stephen M. Miller & Langnan Chen, 2006. "The Making of Optimal and Consistent Policy: An Analytical Framework for Monetary Models," Working papers 2006-05, University of Connecticut, Department of Economics, revised Jan 2009.
  13. Svensson, Lars E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Seminar Papers 646, Stockholm University, Institute for International Economic Studies.
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  17. Leininger, Wolfgang, 1985. "Rawls' Maximin Criterion and Time-Consistency: Further Results," Review of Economic Studies, Wiley Blackwell, vol. 52(3), pages 505-13, July.
  18. V. V. Chari & Patrick J Kehoe, 1998. "Sustainable Plans," Levine's Working Paper Archive 600, David K. Levine.
  19. Georgios E. Chortareas & Stephen M. Miller, 2003. "Monetary Policy Delegation, Contract Costs and Contract Targets," Bulletin of Economic Research, Wiley Blackwell, vol. 55(1), pages 101-112, January.
  20. V. V. Chari, 1988. "Time consistency and optimal policy design," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 17-31.
  21. Rodriguez, Alvaro, 1981. "Rawls' Maximin Criterion and Time Consistency: A Generalization," Review of Economic Studies, Wiley Blackwell, vol. 48(4), pages 599-605, October.
  22. 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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  24. Huiping Yuan & Stephen M. Miller & Langnan Chen, 2009. "The Optimality and Controllability of Monetary Policy through Delegation with Consistent Targets," Working Papers 0909, University of Nevada, Las Vegas , Department of Economics.
  25. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  26. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
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