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Dangers of commitment under rational expectations

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Abstract

Within a New Keynesian framework, interest rate rules that respond to public expectations lead to determinate and expectationally stable solutions for any level of commitment, as shown by Waters (Macroecon Dyn 13(4):421–449, 2009). That paper also demonstrates gains to commitment, under least square learning, though over-commitment can lead to some very poor outcomes for some parameter values. This paper shows an identical outcome under rational expectations. The optimal level of commitment is unchanged if there are observation errors in the policymaker’s knowledge of public expectations, which is not the case under learning. However, if there is sufficient policymaker uncertainty about the parameter values, partial commitment is best.

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Notes

  1. The model here is quite standard. Clarida et al. (1999) provide and excellent overview, and Woodford (2003) presents a detailed, micro-founded approach.

  2. See Evans and Honkapohja (2001) for definitions and mathematical exposition of these concepts.

  3. In earlier studies of commitment, such as Barro and Gordon (1983), the inflation bias arises due to the policymaker’s desire to push output above the natural rate, but that is not the case here. See Clarida et al. (1999) for a detailed discussion.

  4. The present approach follows Evans and Honkapohja (2006), Woodford (1999) and Clarida et al. (1999).

  5. He also checks the result with a formal derivation. Jensen and McCallum (2002) also discuss this issue. Evans and McGough (2008) refer to this approach as the MJB-alternative in their study of the New Keynsian model with inertia.

  6. If the policymaker has a biased estimate of λ, the change in policy would be equivalent to the change caused by varying the policymaker preference parameter α.

  7. For all reported results, the loss for each run is calculated over 200 periods after 600 periods for initialization. Since losses are computed with discounting, longer runs do not provide much extra information.

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Authors and Affiliations

  1. Department of Economics, Illinois State University, Campus Box 4200, Normal, IL, 61761-4200, USA

    George A. Waters

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  1. George A. Waters
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Correspondence to George A. Waters.

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Waters, G.A. Dangers of commitment under rational expectations. J Econ Finan 35, 371–381 (2011). https://doi.org/10.1007/s12197-010-9127-x

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