Discretion and the transmission lags of monetary policy

Juha Kilponen and Kai Leitemo

No 8/2007, Bank of Finland Research Discussion Papers from Bank of Finland

Abstract: Monetary policy transmission lags create credibility problems for the inflationtargeting policy maker who acts under discretion. We show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflationtargeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. We find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags.

Keywords: discretionary and stabilization bias; monetary policy; transmission lags; inflation targeting; money targeting (search for similar items in EconPapers)
JEL-codes: E52 E58 E61 (search for similar items in EconPapers)
Date: 2007
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