New Keynsian model of monetary policy analysis Flashcards
(21 cards)
what is the setup under unconstrained commitment policy?
what is the setup under discretion policy?
under discretion, each period the central bank chooses the triplet {x_t,,π_t,i_t}, consisting of the two target variables and the policy variable which minimise the central banks loss function subject to the Phillips curve and the IS curve. first stage, central bank chooses the optimal values x_t and ,π_t which minimise loss function and then conditional on these target variables, determine the value of I_t which is implied by the IS curve that supports these target variables. Since the central bank cannot credibly manipulate the beliefs in the absence of commitment, the central bank takes private sector expectations as given in the solving of the optimisation problem.
what does the solution for the x_t in terms of π_t under discretion imply?
how do you obtain x_t and π_t in terms of the cost push shock under discretion?
how does the optimal policy incorporate inflation targetting in the discretion result?
what is the inflation target within the model and how does this translate into reality?
the optimal inflation target within the model is 0 whereas in reality it is usually a small positive number. 1-3%
what is the taylor principle under discretion?
how is the optimal interest rate under discretion determined?
how does discretion differ from commitment?
how can you get the solution E_t(π_t+1)=pπ_t
using the method of undetermined coefficients
how do you determine the interest rate in terms of cost push shock?
insert the values of x_t and π_t in terms of the cost push shock into the IS curve to determine the interest rate
what is the paper WALSH 2003 about?
Walsh (2003) evaluates speed limit policy against other alternative policies. speed limit policies target the change in the output gap rather than the output gap itself. the advantages of speed limit targetting is primarily that the optimal condition under discretion with a speed limit target introduces inertia which is similiar to that arising under a precommitment policy. a central bank which is concerned with stabilising the change in the gap will continue to maintain a contractionary policy to dampen this increase in the gap returning the gap to zero gradually as opposed to pure discretion where it instantanously goes back to 0 in the next period
how does speed limit policy compare to other policies, refer to a paper?
Walsh (2003) such as the speed
limit targeting yields the lowest loss; Price level targeting and NIT2 (nominal income growth 2) out performed inflation targeting.
does speed limit policy outperform price level targetting in all scenarios?
no, if inflation adjustment is predominately backwards looking then price level targetting dominates speed limit policy
what is the lagrangian function for the full commitment?
what is the solution to the lagrangian function for full commitment?
what is optimal policy under discretion for a demand shock?
the optimal policy calls for adjusting the interest rate to perfectly offset demand shocks g_t. the simple idea is that countering demand shocks pushes both output and inflation in the right direction therefore demand shcoks do not force a short run tradeoff between output and inflation.
what is the optimal policy under discretion for a shock to potential output z_t?
a shock to potential output does not force a short run tradeoff. a permanent rise in productivity raises potential output but it also raises output demand in a perfectly offsetting manner due to the impact on permanent income. therefore the output gap does not change so there is no reason to rise interest rates despite rise in output. therefore it is vital for the monetary policy to distinguish the sources of buissness cycle shocks
what are the two main sources of inflationary bias and what do they have in common with each othewr??
the ultimate source of inflationary bias is the cewntral banks desire to push output above its naturall level. the second is disinflating the economy may be more painful than necessary especially if monetary policy is perceived as not devoted to fighting inflation. wage and price setting today is dependent on beliefs about future prices which in turn depend on course of monetary policy.
they both have in common that credibility can reduce inflation at a lower cost .
how does the traditional IS curve and the phillips curve differ?
the new keynsian PC and IS curves are derived from the optimisation by households and firms. this has the important impliication that current economic behaviour depends critically on expectations of future monetary policy as well as current monetary policy. the is curve is derived from the consumption euler equation that arises from the households optimal saving decision. the IS curve is different from traditional due to current output depending on expected future output aswell as the interest rate, this is due to individiduals prefering to smooth consumption, so an expectation of higher consumption next period associated with a higher expected output leads them to want to consume more today which raises current output. the negative effect of real rate on current output reflects the intermporal susbstitution of consumption. iterating the IS curve forward, we hget the current output gap is determined by the summ of current and expected future nominal interest rates. therefore credibility of announcements about future policy will be important for macroeconomic performance
the phiillips curve is obtained from the individual firm price setting decision whihcb provides the basis for the aggregate relation, is derived from the optimisation problem. since the equation relates the inflation rate to the output gap it has the flavour of a traditional expectations augmented. a key difference with the traditional phiillips curve is that expected future inflation rather than expected current inflation enters the PC. there is also no arbitary inertia or lagged dependence in the PC, landa is an inverse measure of nominal price rigidity which implies a lower landa means trade off is worse for monetary policy. iterating the PC curve forward tells you inflation depends entirely ion current and expected future economic conditions
s
