OPTIMAL INTEREST RATE RULES UNDER IMPERFECT CREDIBILITY: SOME THEORY AND EVIDENCE

A. Hakan KARA (Central Bank of Turkey and New York University)

In the standard forward-looking models of the recent literature, theoretical optimal monetary policy rules -- computed under perfect credibility -- imply much higher inertia of interest rates than estimated historical policy rules. This paper attempts to reconcile theory with evidence by introducing a theoretical instrument rule that represents the policy under a continuum of credibility. Imperfect credibility is defined as a situation in which the private sector expects the announced policy regime to end sooner than is intended by the policy maker. We find that optimal instruments rules under imperfect credibility exhibit a much closer pattern to the historical rules than the instrument rules computed under perfect credibility. Therefore, much of the discrepancy between theory and evidence may be explained by incorporating an appropriate degree of imperfect credibility. As a by-product, we propose a method to measure the degree of credibility in monetary policy by estimating a structural reaction function. Empirical results suggest that monetary policy in the US during the 80's and the 90's was more credible than the policy pursued in the 70's.