Policy Maker's Credibility with Predetermined Instruments for Forward-Looking Targets

TL;DR

This paper evaluates how the credibility of central bank policies depends on whether policy instruments are predetermined or forward-looking, highlighting the robustness issues of forward-looking rules and advocating for explicit rational behavior modeling.

Contribution

It introduces criteria for selecting monetary policy rules based on instrument timing and models policy maker behavior explicitly using Ramsey optimal policy for improved robustness and credibility.

Findings

Forward-looking rules lack robustness and credibility.

Backward-looking rules align with Ramsey optimal policy.

Explicit modeling of policy maker behavior enhances policy credibility.

Abstract

The aim of the present paper is to provide criteria for a central bank of how to choose among different monetary-policy rules when caring about a number of policy targets such as the output gap and expected inflation. Special attention is given to the question if policy instruments are predetermined or only forward looking. Using the new-Keynesian Phillips curve with a cost-push-shock policy-transmission mechanism, the forward-looking case implies an extreme lack of robustness and of credibility of stabilization policy. The backward-looking case is such that the simple-rule parameters can be the solution of Ramsey optimal policy under limited commitment. As a consequence, we suggest to model explicitly the rational behavior of the policy maker with Ramsey optimal policy, rather than to use simple rules with an ambiguous assumption leading to policy advice that is neither robust nor credible.