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Sophisticated Monetary Policies

Sophisticated Monetary Policies

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Published by Cervino Institute
Andrew Atkeson, V. V. Chari and Patrick J. Kehoe (2009) “Sophisticated Monetary Policies” No 419, Staff Report from Federal Reserve Bank of Minneapolis.

In standard approaches to monetary policy, interest rate rules often lead to indeterminacy. Sophisticated policies, which depend on the history of private actions and can differ on and off the equilibrium path, can eliminate indeterminacy and uniquely implement any desired competitive equilibrium. Two types of sophisticated policies illustrate our approach. Both use interest rates as the policy instrument along the equilibrium path. But when agents deviate from that path, the regime switches, in one example to money; in the other, to a hybrid rule. Both lead to unique implementation, while pure interest rate rules do not. We argue that adherence to the Taylor principle is neither necessary nor sufficient for unique implementation with pure interest rate rules but is sufficient with hybrid rules. Our results are robust to imperfect information and may provide a rationale for empirical work on monetary policy rules and determinacy.
Andrew Atkeson, V. V. Chari and Patrick J. Kehoe (2009) “Sophisticated Monetary Policies” No 419, Staff Report from Federal Reserve Bank of Minneapolis.

In standard approaches to monetary policy, interest rate rules often lead to indeterminacy. Sophisticated policies, which depend on the history of private actions and can differ on and off the equilibrium path, can eliminate indeterminacy and uniquely implement any desired competitive equilibrium. Two types of sophisticated policies illustrate our approach. Both use interest rates as the policy instrument along the equilibrium path. But when agents deviate from that path, the regime switches, in one example to money; in the other, to a hybrid rule. Both lead to unique implementation, while pure interest rate rules do not. We argue that adherence to the Taylor principle is neither necessary nor sufficient for unique implementation with pure interest rate rules but is sufficient with hybrid rules. Our results are robust to imperfect information and may provide a rationale for empirical work on monetary policy rules and determinacy.

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Federal Reserve Bank of MinneapolisResearch Department Sta
ff 
Report 419Revised May 2009
Sophisticated Monetary Policies
Andrew Atkeson
University of California, Los Angeles,Federal Reserve Bank of Minneapolis,and NBER
V. V. Chari
University of Minnesotaand Federal Reserve Bank of Minneapolis
Patrick J. Kehoe
Federal Reserve Bank of Minneapolis,University of Minnesota,and NBERABSTRACTIn standard approaches to monetary policy, interest rate rules often lead to indeterminacy.
So-phisticated policies 
, which depend on the history of private actions and can di
ff 
er on and o
ff 
theequilibrium path, can eliminate indeterminacy and uniquely implement any desired competitiveequilibrium. Two types of sophisticated policies illustrate our approach. Both use interest ratesas the policy instrument along the equilibrium path. But when agents deviate from that path, theregime switches, in one example to money; in the other, to a hybrid rule. Both lead to uniqueimplementation, while pure interest rate rules do not. We argue that adherence to the Taylor prin-ciple is neither necessary nor su
cient for unique implementation with pure interest rate rules butis su
cient with hybrid rules. Our results are robust to imperfect information and may provide adirection for empirical work on monetary policy rules and determinacy.
Atkeson, Chari, and Kehoe thank the National Science Foundation for
nancial support and Kathleen Rolfefor excellent editorial assistance. The views expressed herein are those of the authors and not necessarilythose of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
 
The now-classic Ramsey (1927) approach to policy analysis under commitment speci-
es the set of instruments available to policymakers and
nds the best competitive equilibriumoutcomes given those instruments. This approach has been adapted to situations with uncer-tainty, by Barro (1979) and Lucas and Stokey (1983), among others, by specifying the policyinstruments as functions of exogenous events.
1
While the Ramsey approach has been useful in identifying the best outcomes, thisapproach needs to be extended before it can be used to guide policy. Such an extensionwould describe what would happen for every history of private agent actions, governmentpolicies, and exogenous events. It would also be desirable to structure policy in such a waythat policymakers can ensure that their desired outcomes occur.Here, we provide such an extended approach. To construct it, we extend the languageof Chari and Kehoe (1990) in a natural fashion by describing private agent actions andpolicies as functions of the history of private agent actions, policies, and exogenous events.The key to our approach is our requirement that for all histories, including those in whichprivate agents deviate from the equilibrium path, the continuation outcomes constitute acontinuation competitive equilibrium.
2
We label such policy functions
sophisticated policies 
and the resulting equilibrium a
sophisticated equilibrium 
. If policies can be structured so asto ensure that the desired outcomes occur, then we say that the policies
uniquely implement 
the desired outcome.We use this approach to analyze an important outstanding question in monetary eco-nomics: How should we design policy in order to avoid indeterminacy and to achieve uniqueimplementation? It has been known, at least since the work of Sargent and Wallace (1975),that when interest rates are the policy instrument, many ways of specifying policy lead toindeterminate outcomes. Indeterminacy is risky because some of those outcomes can be bad,including hyperin
ation. Researchers thus agree that designing policies which achieve uniqueimplementation is desirable. Here, we demonstrate that our sophisticated policy approachdoes that for monetary policy.We illustrate our approach in two standard monetary economies: a simple stickyprice model with one-period price-setting and a sticky price model with staggered price-setting, often referred to as the
New Keynesian model 
. For both, we show that, under
 
su
cient conditions, any outcome of a competitive equilibrium can be uniquely implementedby appropriately constructed sophisticated policies. In particular, the Ramsey equilibriumcan be uniquely implemented.We construct central bank policies that uniquely implement a desired competitiveequilibrium in the same basic way in both models. Along the equilibrium path, we choosethe policies to be those given by the desired competitive equilibrium. We structure the policieso
ff 
the equilibrium path, the
reversion 
policies, to discourage deviations. Speci
cally, if theaverage choice of private agents deviates from that in the desired equilibrium, we choose thereversion policies so that the optimal choice, or
best response,
of each individual agent isdi
ff 
erent from the average choice.One way to see why such reversion policies can eliminate multiplicity is to recallhow multiple equilibria arise in the
rst place. At an intuitive level, they arise if wheneach agent believes that all other agents will choose some particular action other than thedesired one, each agent
nds it optimal to go along with the deviation by also picking thatparticular action. Our construction of reversion policies breaks the self-ful
lling nature of such deviations. It does so by ensuring that even if an agent believes that all other agentsare choosing a particular action that di
ff 
ers from the desired action, the central bank policymakes it optimal for that agent not to go along with that deviation.When such reversion policies can be found, we say that the best responses are
con-trollable 
. A su
cient condition for controllability is that policies can be found so that aftera deviation the continuation equilibrium is unique and varies with policy. Variation withpolicy typically holds, so if policies can be found under which the continuation equilibriumis unique (somewhere), then we have unique implementation (everywhere). This su
cientcondition suggests a simple way to state our message in a general way: uniqueness somewheregenerates uniqueness everywhere.One concern with our construction is that it apparently relies on the idea that thecentral bank perfectly observes private agents’ actions and thus can detect any deviation. Weshow that this concern is unwarranted: our results are robust to imperfect information aboutprivate agents’ actions. Speci
cally, with imperfect detection of deviations, sophisticatedpolicies can be designed that have unique equilibria which are close to the desired outcome2

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