url
28
Jul
2014

SIMPLE MONETARY POLICY RULES UNDER MODEL UNCERTAINTY: Conclusions

This paper has investigated the performance of policy rules across four structural macroeconomic models with rational expectations. Although the four models differ in many important respects (e.g., the level of aggregation, the specification of output and price dynamics, and the treatment of the foreign sector), the characteristics of effective policy rules are essentially the same. To stabilize inflation and output at reasonably low levels of interest rate volatility, the policy rule should respond to the current output gap and to a one- to three-year moving average of the inflation rate, and should incorporate a high degree of interest rate smoothing, that is, a coefficient near unity on the lagged funds rate. These results are essentially unchanged even if the policy rule is restricted to react to output and inflation data from the previous rather than the current quarter.

Interest rate smoothing provides the largest gains from any of the permutations of simple policy rules that we have investigated. Several factors contribute to this result:

(i) smooth changes in the short-term interest rate provide control over long-term interest rates and thereby over aggregate demand and inflation at low cost in terms of funds rate volatility;

(ii) constraining interest rate volatility as we do in constructing the frontiers favors interest rate smoothing;

(iii) the lagged interest rate provides a measure of the existing state of the economy in models with output and inflation persistence;

and (iv) with a very high degree of smoothing, such as that associated with first-difference rules, output tends to exhibit “overshooting”, which is preferable to returning monotonically to potential under the standard deviation criteria employed here.

This paper has investigated the performance of policy rules across four structural macroeconomic models with rational expectations. Although the four models differ in many important respects (e.g., the level of aggregation, the specification of output and price dynamics, and the treatment of the foreign sector), the characteristics of effective policy rules are essentially the same. To stabilize inflation and output at reasonably low levels of interest rate volatility, the policy rule should respond to the current output gap and to a one- to three-year moving average of the inflation rate, and should incorporate a high degree of interest rate smoothing, that is, a coefficient near unity on the lagged funds rate. These results are essentially unchanged even if the policy

About The Author

Kevin J. Brandon

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