Monetary policy

Question 1

What is the timing under commitment

Answer 1

Perfect comitment
1. Central bank announces monetary rule
2. Everyone observes the natural level of output θ.
3. Expectations π^e are formed, given the information about θ.
4. Everyone observes v and ϵ
5. The central bank decides the money suplly m

The consequence is that the central bank has an informational advantage, due to expectations are pinned down before the money supply is set by the central bank, last step.

Question 2

Why can monetary policy be a trade off, and what has it to do with expectations.

Answer 2

It is a tradoff between inflation and output stabilization.

Monetary policy can move after our expectations are formed

This is a “reduced form” way of making monetary policy powerfull.
–> it can stabilize output against shocks after expectations are formed.

Lucas argues, that after ouput is realized and the households have formed expectations, then only unexpected changes in monetary policy have an effect. It means that the central bank has to make unexpected changes in the money supply to before it can stabilies any shock.