Hyperbolic Discounting and Macroeconomic Policy

This chapter continues the investigation of the effects of “hyperbolic discounting” (HD) by analysing its implications for short-term stabilisation policy, in particular, monetary policy. The latter takes the form of a “Taylor rule” of interest rate setting. The analysis is quite novel in terms of subject-matter and method. The production setup is an AK model with a temporary output gap arising out of a small menu of shocks with a simple structure—a demand, productivity, and pricing shock. A novelty in relation to Chapter 5 is inflation, which takes the form of a standard New Keynesian Phillips Curve. Thus, a New Keynesian “three-equation” model arises, with a Modified IS curve (from intertemporal optimisation), a Taylor rule, and an inflation equation. Intertemporal optimisation proceeds as in Chapter 5 , albeit in discrete time. It is shown that a rise in exogenous “present bias” takes us closer to a “Keynesian” type of model, in which the standard (Keynesian) government spending multiplier increases (against the result in Chapter 5 ). The same change also has important implications for the optimal design and effectiveness of monetary policy. The effects of financial “present bias” (i.e. myopia) are also briefly investigated.