On the Implementation of Markov-Perfect Monetary Policy

FRB Richmond Working Paper No. 09-6R

22 Pages Posted: 12 Dec 2012

See all articles by Michael Dotsey

Michael Dotsey

Federal Reserve Bank of Philadelphia

Andreas Hornstein

Federal Reserve Bank of Richmond

Multiple version iconThere are 2 versions of this paper

Date Written: July 14, 2011

Abstract

The literature on optimal monetary policy in New Keynesian models under both commitment and discretion usually solves for the optimal allocations that are consistent with a rational expectations market equilibrium, but it does not study whether the policy can be implemented given the available policy instruments. Recently, King and Wolman (2004) have provided an example for which a time-consistent policy cannot be implemented through the control of nominal money balances. In particular, they .nd that equilibria are not unique under a money stock regime and they attribute the non-uniqueness to strategic complementarities in the price-setting process. We clarify how the choice of monetary policy instrument contributes to the emergence of strategic complementarities in the King and Wolman (2004) example. In particular, we show that for an alternative monetary policy instrument, namely, the nominal interest rate, there exists a unique Markov-perfect equilibrium. We also discuss how a time-consistent planner can implement the optimal allocation by simply announcing his policy rule in a decentralized setting.

Keywords: monetary policy, Markov-perfect, determinacy, interest rate rules, money supply rules

JEL Classification: E4, E5, E6

Suggested Citation

Dotsey, Michael and Hornstein, Andreas, On the Implementation of Markov-Perfect Monetary Policy (July 14, 2011). FRB Richmond Working Paper No. 09-6R. Available at SSRN: https://ssrn.com/abstract=2188493 or http://dx.doi.org/10.2139/ssrn.2188493

Michael Dotsey

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States
804-697-8201 (Phone)
804-697-8255 (Fax)

Andreas Hornstein (Contact Author)

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States
804-697-8266 (Phone)
804-697-8255 (Fax)

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