Endogenous Monetary Policy in Macroeconomic Models: The Role of Commitment, Conservative Central Banker and Optimal Central Bank Contracts in the Credibility of Monetary Policy

Pekka Alajääskö

No 36, Research Reports from VATT Institute for Economic Research

Abstract: This study focuses on the motives and constraints of the monetary policy authorities, i.e. the central banks. The fundamental theme is that the policy variable (inflation) is endogenous in the analysis. The behavior of this variable is a consequence of strategic and informational interactions between policymakers and private sector individuals and institutions. It is our aim to integrate old and new contributions of endogenous monetary policy models in a common framework. We will show how in the optimal central bank contract a linear cost of inflation is added to the central bank's loss function. This type of a contract is a perfect substitute for commitments. It enables the policymaker to precommit policy; it makes her policy announcement credible. We will also show that participation in a monetary union is beneficial for an inflation prone country with relatively small output variation. In that case expected gains from less inflation outweigh expected costs from less stabilization the monetary union is assumed to provide. In addition, it will be shown that the bigger the output variation of a country when the country's output is negatively correlated with the monetary union output, the more conservative (more weight on inflation than output stabilization) a central bank governor should be nominated in the country. This is because the more negative the output correlation is, the less weight the country prefers the monetary union to put on output stabilization. Each member country of the Economic and Monetary Union (EMU) can affect the monetary policy pursued by the EMU through its central bank governor.

Keywords: Endogenous monetary policy; credibility; optimal central bank contract; EMU; Macroeconomic policy; Talouspolitiikka; International comparisons; Kansainväliset vertailut; Policy analysis and modelling; Päätöksenteon tuki ja mallintaminen; C700 - Game Theory and Bargaining Theory: General; E500 - Monetary Policy; Central Banking; and the Supply of Money and Credit: General (flow of funds); F000 - International Economics: General (search for similar items in EconPapers)
Date: 1996
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