Stochastic credibility and optimal monetary policy

Abstract

In this paper, I study optimal monetary policy in a simple New Keynesian model with loose commitment and stochastic credibility. The loose commitment framework breaks the commitment-discretion dichotomy in optimal monetary policy problems and allows for intermediate cases between commitment and discretion. Under this framework, the central bank is imperfectly credible, meaning that it occasionally reneges on promised policy plans. I contribute to the literature by introducing time-variation in the central bank's credibility. I model credibility as an exogenous two-state Markov chain and use a recursive saddlepoint functional equation to solve the model. I find that greater persistence and frequency of credibility losses increase welfare losses.