[2021] ‘Macroeconomic theory provides many examples in which the optimal monetary policy is time
inconsistent, but the practical relevance of those examples is limited. Nevertheless, there are other
justifications for the introduction of price path targets for monetary policy authorities.’ Discuss.
(1.1) Optimal policy is time inconsistent in cost-push shock with NKPC (stabilization bias) but PP
targets fix this
o
o Assume no transmission lag
o Non-optimal feasible policy: A > C > A
o Optimal policy with forward guidance: A > C > D > E
NKPC shifts down due to higher expected future inflation
πt = Etπt+1 + k(yt-ye)
(1.2) More efficient but inconsistent
2 small deviations from bliss point rather than 1 large deviation. Given
the quadratic loss function, this is preferred.
[equation] ,
[graph]
Normally time inconsistent since prefer A over E. Ex-ante rational to
commit, ex-post irrational to follow through
(1.3) PP target makes this time consistent
[graph] PP target pi-t graph and log P-t graph.
o [Example] Ukraine war with oil + grain cost push shock, Covid supply chain disruption
cost push shock (semiconductor chips, shipping costs)
(1b) Practical relevance of forward guidance with NKPC depends on whether NKPC holds,
meaning whether sticky prices holds and firms care about future inflation due to possibility of
not being able to change price in next period under Calvo pricing
o Sticky prices are built on menu costs and real rigidities, but little real rigidities observed
(no flat MC as labour supply is relatively inelastic)
, o If NKPC does not hold, forward guidance does not work, this time inconsistent optimal
policy would not work, even if CB can credibly commit to it
(2) Optimal policy is time inconsistent in negative demand shock near ZLB (commitment to
irresponsibility) but PP targets fix this
o
o [Example] Near ZLB since GFC 2008
(2b) Practical relevance of solving ZLB problems with PP targets depends on whether
assumption of RE holds
o At ZLB, PP target imparts stimulus via 2 channels:
o (i) expectations over low future nominal policy rates which lower current long rates
(i) depends mainly on RE in the financial sector
eg. if outlook for short rates is flat, banks infer funding will be cheap and they
pass this on in mortgage and other rates. Strong evidence
o (ii) rise in expected future inflation which reduces current real long rates
(ii) depends mainly on RE in consumer/corporate sectors in that when expected
future inflation increases
Borrowers must infer that existing loan offers are more attractive in real terms
(lower current real long rates) and buy now instead of in the future. Less
evidence
(2c) Practical relevance on efficacy of PP targets depends on convex PC and whether RE holds
o Convex PC can affect the stabilising properties of the PP regime
For a given fall in output (from ye), convex PC implies smaller ↓π
Under the PP regime, this limits the rise in future expected inflation (since a
smaller ↓π now requires a smaller ↑π above the 2% stable rate later to return
to the price path)
Hence, this limits the declines in current real long rates
o This need not impair the stabilising properties of the PP regime
inconsistent, but the practical relevance of those examples is limited. Nevertheless, there are other
justifications for the introduction of price path targets for monetary policy authorities.’ Discuss.
(1.1) Optimal policy is time inconsistent in cost-push shock with NKPC (stabilization bias) but PP
targets fix this
o
o Assume no transmission lag
o Non-optimal feasible policy: A > C > A
o Optimal policy with forward guidance: A > C > D > E
NKPC shifts down due to higher expected future inflation
πt = Etπt+1 + k(yt-ye)
(1.2) More efficient but inconsistent
2 small deviations from bliss point rather than 1 large deviation. Given
the quadratic loss function, this is preferred.
[equation] ,
[graph]
Normally time inconsistent since prefer A over E. Ex-ante rational to
commit, ex-post irrational to follow through
(1.3) PP target makes this time consistent
[graph] PP target pi-t graph and log P-t graph.
o [Example] Ukraine war with oil + grain cost push shock, Covid supply chain disruption
cost push shock (semiconductor chips, shipping costs)
(1b) Practical relevance of forward guidance with NKPC depends on whether NKPC holds,
meaning whether sticky prices holds and firms care about future inflation due to possibility of
not being able to change price in next period under Calvo pricing
o Sticky prices are built on menu costs and real rigidities, but little real rigidities observed
(no flat MC as labour supply is relatively inelastic)
, o If NKPC does not hold, forward guidance does not work, this time inconsistent optimal
policy would not work, even if CB can credibly commit to it
(2) Optimal policy is time inconsistent in negative demand shock near ZLB (commitment to
irresponsibility) but PP targets fix this
o
o [Example] Near ZLB since GFC 2008
(2b) Practical relevance of solving ZLB problems with PP targets depends on whether
assumption of RE holds
o At ZLB, PP target imparts stimulus via 2 channels:
o (i) expectations over low future nominal policy rates which lower current long rates
(i) depends mainly on RE in the financial sector
eg. if outlook for short rates is flat, banks infer funding will be cheap and they
pass this on in mortgage and other rates. Strong evidence
o (ii) rise in expected future inflation which reduces current real long rates
(ii) depends mainly on RE in consumer/corporate sectors in that when expected
future inflation increases
Borrowers must infer that existing loan offers are more attractive in real terms
(lower current real long rates) and buy now instead of in the future. Less
evidence
(2c) Practical relevance on efficacy of PP targets depends on convex PC and whether RE holds
o Convex PC can affect the stabilising properties of the PP regime
For a given fall in output (from ye), convex PC implies smaller ↓π
Under the PP regime, this limits the rise in future expected inflation (since a
smaller ↓π now requires a smaller ↑π above the 2% stable rate later to return
to the price path)
Hence, this limits the declines in current real long rates
o This need not impair the stabilising properties of the PP regime
