Discretion And The Transmission Lags Of Monetary Policy

Monetary policy transmission lags create credibility problems for the inflation targeting policy maker who acts under discretion. The authors show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflation targeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. They find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags.