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We thank Guillermo Calvo and Jeroen Kremers for helpful comments on an earlier draft. We accept sole responsibility for any remaining errors.
A model such as this often includes random shocks in macroeconomic relationships. Since here our focus is on the economy’s response to policy-induced monetary surprises, we consider a limiting case in which the variances of all other unanticipated shocks approach zero.
This solution method requires that current prices and exchange rates have no bearing on expected future values of these variables. This would be consistent with rationality in a model with random shocks to macroeconomic relationships, even though, should the authorities cheat and introduce a positive monetary shock, this would be associated with a higher money supply in the following period, since, in the results to be developed below, cheating occurs with probability zero. Our model must thus be interpreted as a limiting case of such a stochastic framework, where the variances of all the shocks approach zero.
The need to have some distortion in the economy in order to generate activist policy is discussed in Calvo (1978).
The assumption that the loss function is quadratic is obviously quite a specialized one. The implications of alternative loss functions are examined in Fischer and Summers (1988).
For a model of the EMS in which the target level of the exchange rate is allowed to differ from the central rate, see Gros (1988).
This result depends, of course, on our use of the common assumption that the authorities’ loss function is quadratic.