url
7
May
2014

SIMPLE MONETARY POLICY RULES UNDER MODEL UNCERTAINTY: Introduction 3

2015
One major difference between our analysis and much of that in the previous literature is that we compute optimal policy frontiers using large rational expectations macroeconomic models—including models with more than 100 equations-as opposed to traditional structural models or small rational expectations models. Policy rule analysis using traditional models is particularly prone to the Lucas Critique (1976). Fischer (1977) and Phelps and Taylor (1977) made strides in overcoming the inconsistency between policy and expectations inherent in traditional models by using small rational expectations structural models for policy analysis. In the past, policy rule analysis using rational expectations models was hampered by the computational cost in solving and computing moments of models with more than a small number of equations. Analysis was generally limited to the comparison of a small set of policy regimes as in Bryant (1989), Bryant (1993), and Taylor (1993b). Increases in computer speed and the development of efficient solution algorithms have made the computation of optimal frontiers of large linear rational expectations models feasible. Source

We present the policy frontiers in inflation-output volatility space, with each curve corresponding to a particular constraint on the volatility of the first-difference of the funds rate. Interest rate volatility plays a key role in our analysis. All four models share the feature of a tradeoff between interest rate volatility and inflation-output volatility, even at levels of interest rate volatility significantly above those implied by estimated policy rules or observed in the data. That is, the variability of output and inflation can be reduced by using highly aggressive rules, but such rules also induce wild fluctuations in interest rates. In this paper, we focus our attention on rules that feature relatively moderate levels of interest rate volatility.

One major difference between our analysis and much of that in the previous literature is that we compute optimal policy frontiers using large rational expectations macroeconomic models—including models with more than 100 equations-as opposed to traditional structural models or small rational expectations models. Policy rule analysis using traditional models is particularly prone to the Lucas Critique (1976). Fischer (1977) and Phelps and Taylor (1977) made strides in overcoming the inconsistency between policy and expectations inherent in traditional models by using small rational expectations structural models for policy analysis. In the past, policy rule analysis using rational expectations models was hampered by the computational cost in solving and computing moments of models with more than a small number of equations. Analysis

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Kevin J. Brandon

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