Quantifying and sustaining welfare gains from monetary commitment

Abstract

The objectives of this paper are : first, to quantify the stabilization welfare gains from commitment; second, to examine how commitment to an optimal rule can be sustained as an equilibrium and third, to find a simple interest rate rule that closely approximates the optimal commitment one. We utilize an influential empirical micro-founded DSGE model, the euro area model of Smets and Wouters (2003), and a quadratic approximation of the representative household's utility as the welfare criterion. Importantly, we impose the effect of a nominal interest rate zero lower bound. In contrast with previous studies, we find significant stabilization gains from commitment: our central estimate is a 0.4 − 0.5% equivalent permanent increase in consumption, but in a variant with a higher degree of price stickiness, gains of over 2% are found. We also find that a simple optimized commitment rule with the nominal interest rate responding to current inflation and the real wage closely mimics the optimal rule. JEL Classification: E52, E37, E58Keywords: Monetary rules, commitment, discretion, welfare gains. ECB Working Paper Series No 709 January 2007 Non-technical SummaryThis paper has three principle objectives. First, to quantify the stabilization gains from commitment in terms of household welfare. Second, to examine how commitment to an optimal or approximately optimal rule can be sustained as an equilibrium in which reneging hardly ever occurs. And finally, to find a simple interest rate rule that closely approximates the optimal commitment (and complex) rule.We utilize an influential empirical micro-founded dynamic stochastic general equilibrium (DSGE) model of the euro area in which there are four sources of time-inconsistency: from forward-looking pricing, consumption, investment and wage setting. In the absence of commitment, following a shock which diverts the economy from its steady state and given expectations of inflation, the opportunist policy-maker can increase or decrease output by reducing or increasing the interest rate which increases or decreases inflation. This results in a higher variability of inflation and the nominal interest rate under discretion. The latter means that the interest rate zero lower bound constraint is tighter under discretion and its presence increases the stabilization gains from commitment. The constraint can be relaxed by increasing the steady state inflation rate, but at a cost of an increase in the deterministic component of the welfare loss.In terms of methodology our welfare-based loss function uses the 'small distortions' quadratic approximation to the consumer's utility which is accurate if the steady state is close to the social optimum. In assessing this condition we highlight a neglected aspect of typical New Keynesian models: external habit in consumption tends to make labour supply and the natural rate of output too high compared with the social optimum. If the habit effect is sufficiently high and labour market and product market distortions are not too big then, ...

Optimal Fiscal and Monetary Policy, Debt Crisis, and Management

“…In sum, higher public debt overhangs and risk premia do not significantly alter optimal monetary policy, which features properties in agreement with what the literature found in simpler models (notably Schmitt-Grohe and Uribe, 2007 and Levine et al, 2008a). On the contrary, optimal fiscal policy becomes much more reactive to shocks in the presence of higher risk premia.…”

“…First, we systematically compare optimal commitment, time-consistent, and optimized passive fiscal (active monetary) and active fiscal (passive monetary) rules, drawing conclusions about the costs of simplicity. Second, our rules have the desirable property of avoiding a frequent violation of the zero lower bound (ZLB) as in Levine et al (2008a). Finally we extend the analysis on the fiscal side to allow for long-term debt and show that the maturity composition of debt also plays a role in the optimal speed of debt consolidation.…”

“…From Levine et al (2008a) and Benigno and Woodford (2012) we know that the quadratic approximation to welfare is then given by the second-order approximation to the Lagrangian of the Ramsey problem, together with a linear term dependent on the initial value of the forward-looking variables of the system. When the latter is omitted (as is done below), the quadratic welfare approximation corresponds to the timeless approach to the solution.…”

“…12 The LQ solutions for these three policy regimes are now standard -see, for example, Levine et al (2008a) for details. Regarding discretionary policy, recent important contributions by Blake and Kirsanova (2012) and Dennis and Kirsanova (2013) raise the possibility of multiple discretionary equilibria.…”

A fiscal stimulus with deep habits and optimal monetary policy

“…4 See Levine et al (2008) for details of these three monetary policy regimes. Note that these optimized simple rules are shock-dependent and here only apply to a fiscal shock with the assumed persistence.…”