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Federal Reserve Bank of Richmond
Working Paper
On the implementation of Markov-Perfect interest rate and money supply rules : global and local uniqueness
Michael Dotsey
Andreas Hornstein
Abstract

Currently there is a growing literature exploring the features of optimal monetary policy in New Keynesian models under both commitment and discretion. This literature usually solves for the optimal allocations that are consistent with a rational expectations market equiibrium, but it does not study how the policy can be implemented given the available policy instruments. Recently, however, King and Wolman (2004) have shown that a time-consistent policy cannot be implemented through the control of nominal money balances. In particular, they find that equilibria are not unique under a money stock regime. We find that their conclusion of non-uniqueness of Markov-perfect equilibria is sensitive to the instrument of choice. Surprisingly, if, instead, the monetary authority chooses the nominal interest rate, there exists a unique Markov-perfect equilibrium. We then investigate under what conditions a time-consistent planner can implement the optimal allocation by simply announcing his policy rule in a decentralized setting.


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Michael Dotsey & Andreas Hornstein, On the implementation of Markov-Perfect interest rate and money supply rules : global and local uniqueness, Federal Reserve Bank of Richmond, Working Paper 09-06, 2011.
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Keywords: Monetary policy ; Interest rates
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