Working Paper

A Promised Value Approach to Optimal Monetary Policy

Abstract: This paper characterizes optimal commitment policy in the New Keynesian model using a novel recursive formulation of the central bank's infinite horizon optimization problem. In our recursive formulation motivated by Kydland and Prescott (1980), promised inflation and output gap---as opposed to lagged Lagrange multipliers---act as pseudo-state variables. Using three well known variants of the model---one featuring inflation bias, one featuring stabilization bias, and one featuring a lower bound constraint on nominal interest rates---we show that the proposed formulation sheds new light on the nature of the intertemporal trade-off facing the central bank.

Keywords: Commitment; Inflation bias; Optimal policy; Ramsey plans; Stabilization bias; Zero lower bound;

JEL Classification: E61; E63; E52; E32; E62;

https://doi.org/10.17016/FEDS.2018.083

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2018-12-03

Number: 2018-083

Pages: 64 pages