LOOSE COMMITMENT IN MEDIUM-SCALE MACROECONOMIC MODELS: THEORY AND APPLICATIONS

Abstract

This paper proposes a method and a toolkit for solving optimal policy with imperfect commitment. As opposed to the existing literature, our method can be employed in the medium- and large-scale models typically used in monetary policy. We apply our method to the Smets and Wouters model [American Economic Review97(3), 586–606 (2007)], for which we show that imperfect commitment has relevant implications for interest rate setting, the sources of business cycle fluctuations, and welfare.