Front Matter Page
Research Department
Table of Contents
Summary
I. Introduction
II. A Simple Theoretical Example
III. Simulation Examples
IV. Concluding Remarks and Suggested Extensions
List of Tables
Table 1. Effects of Monetary Deceleration with Different Assumptions for Credibility
Table 2. Effects of Monetary Deceleration with Endogenous Credibility.
Table 3. Effects of Monetary Deceleration: Outcomes for Various Objective Function Weights
Table 4. Effects of Monetary Deceleration with a Different Alternative Monetary Policy: Outcomes for Various Objective Function Weights
Figure 1. Calculation of Credibility Parameterρ
References
Summary
The numerical evaluation of policy rules usually assumes that they are credible; hence there is no question that the policies will be followed, and the private sector forms its expectations accordingly. In practice, however, changes in regime, or more basically, changes in operating rules can be readily observed. In the light of the nonzero probability that rules may be abandoned, it seems to be stacking the deck in their favor to assume that expectations are formed on the basis of complete credibility. In general, lack of credibility will make policy less effective in attaining policy goals.
This paper attempts to implement, in a medium-size nonlinear model, an index of credibility reflecting the probability that the rule will be abandoned in favor of a simple alternative rule. The probability assessment is based on assumed knowledge of the authorities’ objective function, of the parameters of the model, and of the distribution of shocks hitting the economy.
The rule considered is an exogenous deceleration of the money supply, leading eventually (at the end of four years) to stable prices. The paper presents numerical simulations of such a path for money with an assumed function for the authorities' objectives, such that in Borne circumstances they would find it desirable to abandon the announced monetary deceleration and instead continue a positive money growth rate forever. The simulations give examples of lack of credibility, which is shown to affect the success of the policy.