Optimal Monetary Policy, Gains from Commitment, and Inflation Persistence

Using a New Keynesian framework, this paper compares the effects on the welfare of optimal monetary policies under commitment and discretion, and examines the consequences of the presence of inflation persistence. A policy under commitment generates a better weighted average of the variances of output and inflation ("dynamic gains"), and eliminates the inflationary bias. Commitment usually delivers a lower variance of inflation and a higher variance of output than those under discretion. The effect of the presence of inflation persistence on the dynamic gains from commitment is somehow surprising: the benefits are increasing in the degree of inflation persistence for moderate levels of persistence. On the other hand, inflation persistence reduces the inflationary bias. Furthermore, under "restricted commitment", where the solution is restricted to be within the same family of rules of the discretionary case, the gains are substantially inferior to those from commitment