Strategic deviations in optimal monetary policy

Fabio Canetg

doi:10.1186/s41937-021-00071-3

Abstract

This paper investigates the circumstances under which a central bank is more or less likely to deviate from the optimal monetary policy rule. The research question is addressed in a simple New Keynesian dynamic stochastic general equilibrium (DSGE) model in which monetary policy deviations occur endogenously. The model solution suggests that higher future central bank credibility attenuates the current period policy trade-off between a stable inflation rate and a stable output gap. Together with the loss of credibility after a policy deviation, this provides the central bank with an incentive to implement past policy commitments. The result is valid even if the central bank may recover credibility with some probability after a policy deviation. My main finding is that the central bank is willing to implement past policy commitments if a sufficient fraction of agents is not aware of the exact end date of the policy commitment. The result challenges the time-inconsistency argument against monetary policy commitments and provides a potential explanation for the repeated implementation of monetary policy commitments in reality.

Highlights

Central banks have recently used more or less explicit policy commitments to manage public expectations
Under which circumstances a central bank is more or less likely to deviate from the announced policy path. It is unclear how future central bank credibility interacts with the incentives to implement past policy commitments
The optimal monetary policy rule with strategic policy deviations shows that the persistence in the output gap as well as the severity of the policy trade-off depend on current and future central bank credibilities

Summary

Introduction

Central banks have recently used more or less explicit policy commitments to manage public expectations. Researchers have recently started to study limited commitment in optimal monetary policy (e.g., Debortoli et al (2014); Debortoli and Lakdawala (2016); Schaumburg and Tambalotti (2007)) In these models, the central bank is exogenously selected to deviate from past policy commitments with a time-invariant, state-independent probability. The results show that higher future expected central bank credibility attenuates the current period policy trade-off between a stable inflation rate and a stable output gap This provides the central bank with an incentive to implement past policy commitments. Bodenstein et al (2012), for example, define forward guidance as the explicit commitment to implement policy in accordance with the optimal monetary policy rule under time-invariant limited credibility. This is important because the allocations off the path on which commitments are honored are exogenous to the central bank problem

Optimal monetary policy under limited commitment

Results

Future central bank credibility and current period allocation