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The stabilisation problem: the case of New Zealand

This paper examines stabilisation bias - the difference between the inferior macroeconomic outcomes attained with discretionary monetary policy relative to the ideal that could be attained with commitment policy. The paper works within the linear-quadratic framework and represents the monetary policy problem for the central bank as setting the interest rate in order to minimise an explicit loss function for macroeconomic variables. The government's problem is one of "optimal negotiation", whereby the government, representing society, joins with the central bank to search for the optimal set of loss function parameters to be embedded in a contract with the central bank. The framework, due to Rogoff (1985), is usefully applied to the case of New Zealand where recent Policy Target Agreements - contracts between the government and the central bank - are interpreted as representing society's preferences between inflation, output and other dimensions of macroeconomic stability. Within the context of an estimated, small open economy model, a sizeable stabilisation bias is found for New Zealand. Substantial reductions in the stabilisation bias can be achieved by strategic optimal delegation behaviour on the part of the government. It transpires that the weight the central bank should have on the variance of the output gap is considerably lower than the weight society places on the variance of the output gap.

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File URL: http://www.rbnz.govt.nz/research_and_publications/discussion_papers/2003/dp03_08.pdf
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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2003/08.

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Length: 37p.
Date of creation: Nov 2003
Date of revision:
Handle: RePEc:nzb:nzbdps:2003/08
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  1. Richard Dennis, 2003. "Exploring the Role of the Real Exchange Rate in Australian Monetary Policy," The Economic Record, The Economic Society of Australia, vol. 79(244), pages 20-38, 03.
  2. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  3. Henrik Jensen, 2002. "Targeting Nominal Income Growth or Inflation?," American Economic Review, American Economic Association, vol. 92(4), pages 928-956, September.
  4. Bennett T. McCallum & Edward Nelson, . "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," GSIA Working Papers 1997-71, Carnegie Mellon University, Tepper School of Business.
  5. Adolfson, Malin, 2002. "Implications of Exchange Rate Objectives under Incomplete Exchange Rate Pass-Through," Working Paper Series 135, Sveriges Riksbank (Central Bank of Sweden).
  6. Ken West, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2003/09, Reserve Bank of New Zealand.
  7. Jeffery D. Amato & Thomas Laubach, 2001. "Implications of habit formation for optimal monetary policy," Finance and Economics Discussion Series 2001-58, Board of Governors of the Federal Reserve System (U.S.).
  8. Carl Walsh, 2001. "Speed Limit Policies: The Output Gap and Optimal Monetary Policy," CESifo Working Paper Series 609, CESifo Group Munich.
  9. Gaspar, Vitor & Smets, Frank, 2002. "Monetary Policy, Price Stability and Output Gap Stabilization," International Finance, Wiley Blackwell, vol. 5(2), pages 193-211, Summer.
  10. Svensson, L.E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Papers 646, Stockholm - International Economic Studies.
  11. Dennis, Richard & Söderström, Ulf, 2002. "How Important Is Precommitment for Monetary Policy?," Working Paper Series 139, Sveriges Riksbank (Central Bank of Sweden).
  12. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  13. Alfred V. Guender, 2002. "On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model," Pacific Basin Working Paper Series 2002-04, Federal Reserve Bank of San Francisco.
  14. David Hargreaves, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 66, pages 2, September.
  15. Paul Levine & Joseph Pearlman, 2002. "Delegation and Fiscal Policy in the Open Economy: More Bad News for Rogoff's Delegation Game," Open Economies Review, Springer, vol. 13(2), pages 153-174, April.
  16. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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