Do the New Keynesian Microfoundations Rationalise Stabilisation Policy?

Systematic monetary policy is analysed in a two-period extension of standard, static New Keynesian models. It is shown that countercyclical policies increase the band of inaction of the price setters, and that this feedback effect on price rigidity may make such policies "self-justifying"; that is, the policies themselves cause the fluctuations that they are stabilising. Moreover, countercyclical policies may, in general, reduce welfare. In fact, socially optimal policies may very well involve a commitment to enhance shocks. Copyright 2002 Royal Economic Society