A Promised Value Approach to Optimal Monetary Policy

Abstract

This paper characterizes optimal commitment policy in the New Keynesian model using a recursive formulation of the central bank’s infinite horizon optimization problem in which promised inflation and output gap – as opposed to lagged Lagrange multipliers – act as pseudo-state variables. Our recursive formulation is motivated by Kydland and Prescott (1980).
Using three well known variants of the model – one featuring inflation bias, one featuring stabilization bias, and one featuring a lower bound constraint on nominal interest rates – we show that the proposed formulation sheds new light on the nature of the intertemporal trade-off facing the central bank.