url
3
May
2014

SIMPLE MONETARY POLICY RULES UNDER MODEL UNCERTAINTY: Introduction

20090730_0027
In the face of uncertainty about the true structure of the economy, policymakers may disagree about the macroeconomic effects of monetary policy and thus about the appropriate policy setting. One approach to resolving this problem is to search for monetary policy rules that work well across a wide range of structural models; that is, rules that are robust to model uncertainty.1 In this paper, we investigate the characteristics of policy rules that yield low output and inflation volatility across four different structural macroeconometric models of the U.S. economy: the FRB staff model (cf. Brayton 1997a), the MSR model of Orphanides and Wieland (1997),2 the Fuhrer-Moore (1995) model (henceforth referred to as the FM model), and Taylor^ (1993b) Multi-Country Model (henceforth TAYMCM). All four models incorporate the assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in many other respects (e.g., the dynamics of prices and real expenditures). Source

We compute the inflation-output volatility frontier of each model for alternative specifications of the interest rate rule, subject to an upper bound on nominal interest rate volatility. We then evaluate robustness to model uncertainty by taking the rules that perform well in one model and measuring their performance in each of the other three models.

Our analysis provides strong support for rules in which the first-difference of the federal funds rate responds to the current output gap and the deviation of the one-year average inflation rate from a specified target. First, in all four models, first-difference rules perform much better than rules of the type considered by Taylor (1993) and Henderson and McKibbin (1993), in which the level of the federal funds rate responds to the output gap and inflation deviation from target. Second, more complicated rules (that is, rules that respond to a larger number of variables and/or additional lags of the output gap and inflation) typically generate very small gains in stabilizing output and inflation compared with optimal first-difference rules.

In the face of uncertainty about the true structure of the economy, policymakers may disagree about the macroeconomic effects of monetary policy and thus about the appropriate policy setting. One approach to resolving this problem is to search for monetary policy rules that work well across a wide range of structural models; that is, rules that are robust to model uncertainty.1 In this paper, we investigate the characteristics of policy rules that yield low output and inflation volatility across four different structural macroeconometric models of the U.S. economy: the FRB staff model (cf. Brayton 1997a), the MSR model of Orphanides and Wieland (1997),2 the Fuhrer-Moore (1995) model (henceforth referred to as the FM model), and Taylor^ (1993b) Multi-Country Model (henceforth

About The Author

Kevin J. Brandon

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