Vitale: Optimal Monetary Policy for a Pessimistic Central Bank

ABSTRACT:

We extend Svensson’s (Svensson, 1997) model of optimal monetary policy to the case in which the monetary authorities are pessimistic. With respect to his formulation we show that: i) the inflation forecast is not longer an explicit intermediate target; ii) the monetary authorities move their instruments to hedge against the worst economic shocks, do not expect the inflation rate to mean revert to its first-best level and apply a more aggressive Taylor rule; and iii) the inflation rate is less volatile. Our conclusions also hold when the monetary authorities observe inflation and output gap with a time lag. Our analysis extends the analysis of van der Ploeg (van der Ploeg, 2009), as we allow for time-discounting of future social welfare losses due to deviations of output and inflation from first-best values.

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