The Science of Monetary Policy: A New Keynesian Perspective

TLDR: In contrast to conventional wisdom, this paper showed that gains from commitment may emerge even if the central bank is not trying to inadvisedly push output above its natural level, and also considered the implications of frictions such as imperfect information.

Abstract: The paper reviews the recent literature on monetary policy rules. We exposit the monetary policy design problem within a simple baseline theoretical framework. We then consider the implications of adding various real world complications. Among other things, we show that the optimal policy implicitly incorporates inflation targeting. We also characterize the gains from making a credible commitment to fight inflation. In contrast to conventional wisdom, we show that gains from commitment may emerge even if the central bank is not trying to inadvisedly push output above its natural level. We also consider the implications of frictions such as imperfect information.

Figures

Fig 3: Efficient Policy Frontier for Different Values of φ

Fig 1: Efficient Policy Frontier for the Baseline Model

Fig 2: aπ for different values of φ

Fig 5: Target Based On Estimated Post-October '79 Rule vs. Actual Funds Rate

Fig 6: Targets from Forward vs. Backward Looking Rules

Fig 4: The Federal Funds Rate and the Inflation Rate

Full text

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