A Promised Value Approach to Optimal Monetary Policy

Abstract

This paper characterizes optimal commitment policy in the New Keynesian model using a novel recursive formulation of the central bank's infinite horizon optimization problem. In our recursive formulation motivated by Kydland and Prescott (1980), promised inflation and output gap-as opposed to lagged Lagrange multipliers-act as pseudo-state variables. Using three well known variants of the model-one featuring inflation bias, one featuring stabilization bias, and one featuring a lower bound constraint on nominal interest rateswe show that the proposed formulation sheds new light on the nature of the intertemporal trade-off facing the central bank.

Review of Solution and Estimation Methods for Nonlinear Dynamic Stochastic General Equilibrium Models with the Zero Lower Bound

“…The simulation-based method stems from the original work of Marcet's (1988) PEA. Applications to New Keynesian models are found in Maliar and Maliar (2015), Lepetuyk et al (2017), Aruoba et al (2018) and Hills et al (2018).…”