Working Paper: CEPR ID: DP274
Authors: Nicos M. Christodoulakis; Jessica Gaines; Paul Levine
Abstract: This paper proposes and applies to the London Business School (LBS) model a general methodology for the design of macroeconomic policy using large rational expectations models. Design proceeds through the following four stages: first, a small, linear representation of the original large, nonlinear model is obtained. Second, control techniques adapted to ration al expectations models are applied. These result in optimal, open-loop trajectories for both the instruments and the endogenous variables, plus a feedback rule which stabilizes the economy about its open-loop path. The optimal policy is only optimal ex ante. Ex post it ceases to be optimal and there exists an incentive to renege. This is the problem of time inconsistency. In the absence of a reputation for precommitment the optimal policy will lack credibility and the policy-maker must be constrained to a sub-optimal policy from which there is no incentive to renege. The paper examines the possibility that a concern to maintain reputation may be sufficient to sustain the optimal, but time-inconsistent, policy.
Keywords: macroeconomic policy design; econometric models; rational expectations models; time consistency; simple rules
JEL Codes: 133; 212; 311; 321
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lack of credibility in optimal policies (E61) | suboptimal outcomes (I14) |
| reputational concerns (M14) | policy credibility (G52) |
| rule simplicity (C20) | effective policy implementation (D78) |
| feedback rule complexity (C69) | effective policy implementation (D78) |
| application of control techniques adapted to rational expectations models (C53) | stabilization of the economy (E63) |