Credibility of History-Dependent Monetary Policies and Macroeconomic Instability

Gino Cateau () and Malik Shukayev ()
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Gino Cateau: Bank of Canada
Malik Shukayev: University of Alberta, Department of Economics, Postal: 8-14 HM Tory Building, Edmonton, AB, T6G 2H4

No 2016-7, Working Papers from University of Alberta, Department of Economics

Abstract: This paper evaluates the desirability of history-dependent policy frameworks when the central bank cannot perfectly commit to maintain a level target path. Specifically, we consider a central bank that seeks to implement optimal policy under commitment in a simple New Keynesian model via a price-level (or nominal GDP level) target rule. However, the central bank retains the option to reset its target path if the social cost of not doing so exceeds a certain threshold. We find that endowing the central bank with the discretion to optimally reset its target path weakens the effectiveness of the history dependent framework to stabilize the economy through expectations. The endogenous nature of credibility brings novel results relative to models where the timing of target resets is exogenous. First, the central bank needs a high degree of policy credibility to realize the stabilization benefits associated with committing to a price-level target. In our benchmark calibration, the price-level target must be expected to last for 10 years to bridge three quarters of the welfare gap between discretion and full commitment. Second, there is a possibility of multiple equilibria. Indeed, it is possible to have a high credibility equilibrium where the probability of resetting the target is small. But it is also possible to have a low credibility equilibrium where the target is reset much more frequently leading inflation and output to be permanently more volatile.

Keywords: monetary policy commitment; price-level targeting; nominal-income targeting; multiple equilibria; policy credibility (search for similar items in EconPapers)
JEL-codes: E31 E52 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2016-06-08
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-net
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Persistent link: https://EconPapers.repec.org/RePEc:ris:albaec:2016_007

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