Monetary Policy Under Imperfect Commitment: Reconciling Theory with Evidence

International Journal of Central Banking, Forthcoming

30 Pages Posted: 31 Jan 2007

See all articles by Hakan Kara

Hakan Kara

Central Bank of Turkey; Bilkent University

Abstract

In the standard forward-looking models of the recent literature, theoretical optimal monetary policy rules imply much higher inertia of interest rates than estimated historical policy rules. Motivated by the observation that theoretical policy rules often assume perfect commitment on the part of the monetary authority, this study formulates the monetary policy behavior with a continuum from discretion to full commitment and, using this setup, seeks to match the theory with evidence. It is shown that optimal instrument rules under imperfect commitment exhibit less inertia on the policy instrument; the degree of inertia declines as the policy moves from full commitment to discretion. Therefore, under the assumption that the monetary authorities operate somewhere in between discretion and commitment, historically observed policy behavior can be reconciled with the optimal policy rules—even in a purely forward-looking framework. As a by-product, we propose a method to measure the stance of monetary policy from the perspective of discretion versus commitment. To test our proposal, we estimate a structural monetary policy rule for the Federal Reserve, which nests discretion and commitment as special cases. Empirical results suggest that recent practice of monetary policy has been closer to commitment than the policy pursued in the 1970s.

Keywords: Optimal Monetary Policy, Commitment, Credibility

JEL Classification: E52, E58

Suggested Citation

Kara, A. Hakan, Monetary Policy Under Imperfect Commitment: Reconciling Theory with Evidence. International Journal of Central Banking, Forthcoming, Available at SSRN: https://ssrn.com/abstract=960416

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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