Quantifying and Sustaining Welfare Gains from Monetary Commitment

By Paul Levine, Peter Mcadam, Joseph Pearlman. Social Science Research Network, 2007

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The objectives of this paper are: first, to quantify the stabilization welfare gains from commitment; second, to examine how commitment to an optimal rule can be sustained as an equilibrium and third, to find a simple interest rate rule that closely approximates the optimal commitment one. We utilize an influential empirical micro-founded DSGE model, the euro area model of Smets and Wouters (2003), and a quadratic approximation of the representative household's utility as the welfare criterion. Importantly, we impose the effect of a nominal interest rate zero lower bound. In contrast with previous studies, we find significant stabilization gains from commitment: our central estimate is a 0.4 - 0.5% equivalent permanent increase in consumption, but in a variant with a higher degree of price stickiness, gains of over 2% are found. We also find that a simple optimized commitment rule with the nominal interest rate responding to current inflation and the real wage closely mimics the optimal rule.

Subfields: Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/13865c4a94cb0a38489da627a3c4c1d40b44960d