Time consistent monetary policy reconsidered: may we have a deflationary bias too? Southampton, UK, University of Southampton, 23pp.
(Discussion Papers in Economics and Econometrics, 0004).
The celebrated inflationary bias of time consistent monetary policy is re-examined. To this end we consider an extended version of the simple Barro and Gordon framework featuring important aspects of actual policy making such as imperfect instrument control, overlapping wage contracts, policy lags and interest rate control. The model developed provides a counterexample to the standard theory as it yields the result that a deflationary bias may be possible as well. The rationale for this surprising result is found in the distortion caused by instrument uncertainty in the trade-off between the costs and benefits associated with surprisingly lower interest rates faced at the margin by the policy maker. If the size of uncertainty is relatively large the distortion created may imply an optimal choice for the instrument which trades off the marginal benefit of lower deflation against the marginal cost of higher than optimal output. The implications of imprecise instrument control for welfare are discussed too.
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