Strategic Deviations in Optimal Monetary Policy

Abstract

This paper investigates the circumstances under which a central bank is more or less likely to deviate from the optimal monetary policy rule. The research questions is addressed in a simple New Keynesian dynamic stochastic general equilibrium (DSGE) model in which monetary policy deviations occur endogenously. The model solution suggests that higher future central bank credibility attenuates the current period policy trade-off between a stable inflation rate and a stable output gap. Together with the loss of credibility after a policy deviation, this provides the central bank with an incentive to implement past policy commitments. My main result shows that the central bank is willing to implement past policy commitments if a sufficient fraction of agents is not aware of the exact end date of the policy commitment. This finding challenges the time-inconsistency argument against monetary policy commitments and provides a potential explanation for the repeated implementation of monetary policy commitments in reality.