url
14
Jul
2014

SIMPLE MONETARY POLICY RULES UNDER MODEL UNCERTAINTY: Comparison of Alternative Simple Rules 4

We find that the range of values ofp along the frontier declines from [0.85,0.95] to [0.56,0.8].
In the MSR model, we replace the eight-quarter duration bond with the current funds rate in the consumption and investment equations and find that the range of coefficients on the lagged federal funds rate along the frontier declines from [1.0 ,1.1] to [0.75,1.0].

Thus, in both models, the optimal coefficient on the lagged funds rate is significantly reduced when the duration of the long rate is shortened, suggesting that the ability to create large movements in the long-term bond rate with small but persistent movements in the short rate is one of the principal explanations for the superior performance of interest rate smoothing rules in these forward-looking models.

However, because we compare frontiers for inherently second-best policy rules, that is, we constrain interest rate volatility and consider simple rules, we conjecture that the following three factors also play a role in generating the superior performance of interest rate smoothing:

(i) the hypothesized preference for low volatility in the first difference of the interest rate may bias our results in favor of rules with a large coefficient on the lagged funds rate;

(ii) output dynamics tend to exhibit overshooting under rules with 1, which can help stabilize output in terms of variances due to the forward-looking nature of the spending equations in our models;

(iii) by including the lagged funds rate, the policy rule implicitly responds to lagged as well as current values of the output gap and inflation rate, and thus incorporates more information about the state of the economy.

We find that the range of values ofp along the frontier declines from [0.85,0.95] to [0.56,0.8]. In the MSR model, we replace the eight-quarter duration bond with the current funds rate in the consumption and investment equations and find that the range of coefficients on the lagged federal funds rate along the frontier declines from [1.0 ,1.1] to [0.75,1.0]. Thus, in both models, the optimal coefficient on the lagged funds rate is significantly reduced when the duration of the long rate is shortened, suggesting that the ability to create large movements in the long-term bond rate with small but persistent movements in the short rate is one of the principal explanations for the superior performance of interest rate smoothing rules

About The Author

Kevin J. Brandon

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