We have argued that the key to dealing with a situation in which monetary
policy is constrained by the zero lower bound on short-term nominal
interest rates is the skillful management of expectations regarding the
future conduct of policy. By "management of expectations" we do not
mean that the central bank should imagine that, if it uses sufficient guile,
it can lead the private sector to believe whatever the central bank wishes it
to believe, no matter what it actually does. Instead we have assumedabout. But we do contend that it is highly desirable for a central bank to be
able to commit itself in advance to a course of action that is desirable
because of the benefits that flow from its being anticipated, and then to
work to make that commitment credible to the private sector.
In the context of a simple optimizing model of the monetary transmission
mechanism, we have shown that a purely forward-looking approach
to policy—which allows for no possibility of committing future policy to
respond to past conditions—can lead to quite bad outcomes in the event
of a temporary decline in the natural rate of interest, regardless of the kind
of policy pursued at the time of the disturbance. We have also characterized
optimal policy, under the assumption that credible commitment is
possible, and shown that it involves a commitment to eventually bring the
general price level back up to a level even higher than would have prevailed
had the disturbance never occurred. Finally, we have described a
type of history-dependent price-level targeting mle with the following
properties: that a commitment to base interest rate policy on this mle
determines the optimal equilibrium, and that the same foim of targeting
mle continues to describe optimal policy regardless of which of a large
number of types of disturbances may affect the economy.
Given the role of private sector anticipation of history-dependent policy
in realizing a desirable outcome, it is important for central banks to
develop effective methods of signaling their policy commitments to the
private sector. An essential precondition for this, certainly, is for the central
bank itself to clearly understand the kind of history-dependent behavior
to which it should be seen to be committed. It can then communicate
its thinking on the matter and act consistently with the principles that it
wishes the private sector to understand. Simply conducting policy in
accordance with a mle may not suffice to bring about an optimal, or
nearly optimal, equilibrium, but it is the place to start.
