Working Paper: CEPR ID: DP338
Authors: Tamer Baraq; Mark Salmon
Abstract: In this paper we solve for the optimal (Stackelberg) policy in a model of credibility and monetary policy developed by Cukierman and Meltzer. Unlike the (Nash) solution provided by Cukierman and Meltzer, the dynamic optimization problem facing the monetary authority in this case is not of a linear quadratic form and certainty equivalence does not apply. The learning behavior of the private sector (regarding the policymaker's preferences) becomes intimately linked with the choice of the optimal policy and cannot be separated as in the certainty equivalent case. Once the dual effect of the optimal Stackelberg policy is recognized, the monetary authority has an additional channel of influence to consider beyond that taken into account by sub-optimal, certainty equivalent, Nash policy rules.
Keywords: monetary policy; asymmetric information; time consistency
JEL Codes: 023; 026; 311
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal Stackelberg policy (D43) | inflation outcomes (E31) |
| learning behavior of the private sector (D22) | monetary authority's incentive to cheat (E49) |
| Nash solution (C72) | suboptimal for the monetary authority (E49) |
| optimal policy (C61) | account for asymmetry in information (D82) |
| dual control aspect of the optimal policy (E61) | influence expectations formed by the private sector (D84) |
| Stackelberg solution (D43) | credible commitment (D86) |
| interaction of policy with the private sector's learning process (D78) | derive optimal policy (C61) |