Monetary Policy without Commitment

Abstract

This paper studies the implications of central bank credibility for long-run inflation and inflation dynamics.We introduce central bank lack of commitment into a standard non-linear New Keynesian economy with sticky-price monopolistically competitive firms.Inflation is driven by the interaction of lack of commitment and the economic environment.We show that long-run inflation increases following an unanticipated permanent increase in the labor wedge or decrease in the elasticity of substitution across varieties.In the transition, inflation overshoots and then gradually declines.Quantitatively, the inflation response is large, as is the welfare loss from lack of commitment relative to inflation targeting.

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