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Revised: "Managing Beliefs about Monetary Policy under Discretion"

posted Nov 14, 2011, 12:42 PM by Elmar Mertens   [ updated Nov 19, 2011, 5:13 AM ]
The paper (pdf) derives the optimal, time-consistent policy when the policymaker has private information, e.g. about future fundamentals or about his policy targets, in a generic linear-quadratic framework.

New in this revsion is an analysis of optimal disinflation policies after a drop in the policymaker's inflation target and in the presence of multiple frictions (sticky prices and wages) as well as multiple sources of uncertainty.

Many economists have argued about the optimal disninflation strategy when credibility is at stake, and when inflation is highly inertial. My framework allows to study policy design in an explicitly optimizing framework.

When inflation is highly inertial -- say, because of a strong backward-looking component in the Phillips Curve -- the optimal policy does not go "cold turkey" in a rapid disinflation. However, when the inflation target cannot be directly observed by the public, optimal monetary policy is tighter and raises the real rate by more, than when the new target were well known by the public.

Also, while intransparency about output targets might be welfare enhancing, losses are larger in my model when the inflation target lacks transparency.

See my working papers for more.