Using a projection method to analyze inflation bias in a micro-founded model

Abstract

Since Kydland and Prescott (1977) and Barro and Gordon (1983), most studies of the problem of the inflation bias associated with discretionary monetary policy have assumed a quadratic loss function. We depart from the conventional linear-quadratic approach to the problem in favor of a projection method approach. We investigate the size of the inflation bias that arises in a microfounded nonlinear environment with Calvo price setting. The inflation bias is found to lie between 1% and 6% for a reasonable range of parameter values, when the bias is defined as the steady-state deviation of the discretionary inflation rate from the optimal inflation rate under commitment.

Computing Economic Equilibria Using Projection Methods

“…Global methods can fully exploit the nonlinearities obscured by linear approximations and thereby produce inference that is more consistent with the observed macroeconomic phenomena. Anderson et al (2010), for example, find that-in comparison to a nonlinear solution obtained via Chebyshev collocation-linear-quadratic approximation heavily underestimates the inflation bias implied by Calvo-type price stickiness.…”