Unconventional Policy Instruments in the New Keynesian Model

IMF Working Papers, March 10, 2016

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Unconventional Policy Instruments in the New Keynesian Model

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Bibliographic details

• Authors: Zineddine Alla, Raphael A Espinoza, Atish R. Ghosh
• Published: March 10, 2016
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781513573038.001

Overview

• Paper analyzes the use of unconventional policy instruments in New Keynesian setups in which the ‘divine coincidence’ breaks down.
• Discusses the role of a second instrument and its coordination with conventional interest rate policy.
• Presents theoretical results on equilibrium determinacy, the inflation bias, the stabilization bias, and the optimal central banker’s preferences when both instruments are available.

Theoretical results

• Introducing a second (unconventional) instrument can:
  • Reduce the zone of equilibrium indeterminacy.
  • Reduce the volatility of the economy.
• In some circumstances, committing not to use the second instrument may be welfare improving (analogous to Rogoff (1985a) example of counterproductive coordination).
• When price setting depends on expectations about the future, any instrument that affects these expectations can yield credibility gains.

Findings on policy interactions and biases

• Equilibrium determinacy:
  • Use of an unconventional instrument can shrink the region of indeterminate equilibria.
• Inflation bias and stabilization bias:
  • The presence of a second instrument affects both the inflation bias and the stabilization bias; the paper provides theoretical characterizations of these effects.
• Volatility:
  • Availability and appropriate use of the unconventional instrument can lower macroeconomic volatility.

Optimal central banker preferences and behavior

• The optimal central banker should:
  • Be aggressive against inflation.
  • Be interventionist in using the unconventional policy instrument.
• Credibility considerations:
  • Establishing credibility by using instruments that shape expectations has welfare gains as long as price setting depends on expectations about the future.
• Coordination trade-offs:
  • There exist cases where refraining from using the unconventional instrument (commitment not to use it) improves welfare, indicating potential counterproductive coordination problems.

Policy recommendations and implications

• Consider incorporating unconventional instruments alongside conventional interest rate policy to improve determinacy and reduce volatility.
• Evaluate the potential welfare trade-offs of committing to not use unconventional instruments in specific circumstances.
• Design central bank preferences and operational frameworks to be both inflation-focused and willing to actively deploy unconventional tools when they affect expectations and outcomes.

Subjects and keywords

• Subjects: Banking, Financial frictions, Inflation, Neoclassical theory, Output gap
• Keywords: WP

Source: Unconventional Policy Instruments in the New Keynesian Model, Zineddine Alla, Raphael A Espinoza, and Atish R. Ghosh, March 10, 2016.

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