Quantifying and sustaining welfare gains from monetary commitment

Paul Leslie Levine (), Peter McAdam and Joseph Gerson Pearlman ()

No 709, Working Paper Series from European Central Bank

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, E58.

Keywords: Monetary rules; commitment; discretion; welfare gains. (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2007-01
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