DP338 | Credibility and the Value of Information Transmission in a Model of Monetary Policy and Inflation

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01/10/1989

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Abstract

In this paper we solve for the optimal (Stackelberg) policy in a model of credibility and monetary policy developed by Cukierman and Meltzer. Unlike the (Nash) solution provided by Cukierman and Meltzer, the dynamic optimization problem facing the monetary authority in this case is not of a linear quadratic form and certainty equivalence does not apply. The learning behavior of the private sector (regarding the policymaker's preferences) becomes intimately linked with the choice of the optimal policy and cannot be separated as in the certainty equivalent case. Once the dual effect of the optimal Stackelberg policy is recognized, the monetary authority has an additional channel of influence to consider beyond that taken into account by sub-optimal, certainty equivalent, Nash policy rules.