Optimal Monetary Policy, Commitment, and Imperfect Credibility

Central Bank of Turkey Discussion Paper No. 61

38 Pages Posted: 5 May 2003

See all articles by Hakan Kara

Hakan Kara

Central Bank of Turkey; Bilkent University

Date Written: January 2003

Abstract

In the conventional optimal monetary policy framework, two key assumptions underline the full commitment solution: Monetary authority is perfectly credible, and can commit for an infinite number of periods. Using a baseline forward looking model, this study explores the implications of relaxing these assumptions in turn. First, finite lasting commitments are introduced using a stochastic exogenous process that generates policy reoptimizations. As a consequence, monetary policy is characterized with a continuum from pure discretion to full commitment. Second, we solve the optimal and robust targeting rules when the central bank confronts imperfect and/or uncertain credibility. Imperfect credibility is defined as a situation in which the private sector expects the commitment regime to end sooner than that is intended by the policy maker. The results indicate that, under imperfect credibility, optimal policy becomes observationally closer to the discretionary solution, the more being so as the degree of uncertainty rises. These findings may be insightful for explaining the observed near-discretionary behavior of the central banks, which indeed operate under imperfect credibility.

Keywords: Optimal monetary policy, stabilization bias, imperfect credibility, discretion, commitment

JEL Classification: E52, E58

Suggested Citation

Kara, A. Hakan, Optimal Monetary Policy, Commitment, and Imperfect Credibility (January 2003). Central Bank of Turkey Discussion Paper No. 61, Available at SSRN: https://ssrn.com/abstract=383300 or http://dx.doi.org/10.2139/ssrn.383300

A. Hakan Kara (Contact Author)

Central Bank of Turkey ( email )

Istiklal Cad. 10 Ulus
06100 Ankara
Turkey

Bilkent University ( email )

Bilkent, Ankara 06533
Turkey
06800 (Fax)

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