Advanced Search
MyIDEAS: Login to save this article or follow this journal

Robust Monetary Policy Rules with Unknown Natural Rates

Contents:

Author Info

  • Athanasios Orphanides

    (Board of Governors, Federal Reserve)

  • John C. Williams

    (Federal Reserve Bank of San Francisco)

Abstract

We examine the performance and robustness properties of alternative monetary policy rules in the presence of structural change that renders the natural rates of interest and unemployment uncertain. Using a forward-looking quarterly model of the U.S. economy, estimated over the 1969-2002 period, we show that the cost of underestimating the extent of misperceptions regarding the natural rates significantly exceeds the costs of overestimating such errors. Naive adoption of policy rules optimized under the false presumption that misperceptions regarding the natural rates are likely to be small proves particularly costly. Our results suggest that a simple and effective approach for dealing with ignorance about the degree of uncertainty in estimates of the natural rates is to adopt difference rules for monetary policy, in which the short-term nominal interest rate is raised or lowered from its existing level in response to inflation and changes in economic activity. These rules do not require knowledge of the natural rates of interest or unemployment for setting policy and are consequently immune to the likely misperceptions in these concepts. To illustrate the differences in outcomes that could be attributed to the alternative policies we also examine the role of misperceptions for the stagflationary experience of the 1970s and the disinflationary boom of the 1990s.

(This abstract was borrowed from another version of this item.)

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2002_2_bpea_papers/2002b_bpea_orphanides.pdf
Download Restriction: no

Bibliographic Info

Article provided by Economic Studies Program, The Brookings Institution in its journal Brookings Papers on Economic Activity.

Volume (Year): 33 (2002)
Issue (Month): 2 ()
Pages: 63-146

as in new window
Handle: RePEc:bin:bpeajo:v:33:y:2002:i:2002-2:p:63-146

Contact details of provider:
Postal: 1775 Massachusetts Ave NW, Washington DC 20036
Phone: (202) 797-6000
Fax: (202) 797-6004
Email:
Web page: http://www.brookings.edu/economics.aspx
More information through EDIRC

Related research

Keywords: macroeconomics; Robust Monetary Policy Rules; Natural Rates;

Other versions of this item:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Bennett T. McCallum & Edward Nelson, 1999. "Performance of Operational Policy Rules in an Estimated Semiclassical Structural Model," NBER Chapters, in: Monetary Policy Rules, pages 15-56 National Bureau of Economic Research, Inc.
  2. Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond.
  3. Eric T. Swanson, 2000. "On signal extraction and non-certainty-equivalence in optimal monetary policy rules," Finance and Economics Discussion Series 2000-32, Board of Governors of the Federal Reserve System (U.S.).
  4. Arthur M. Okun & Nancy H. Teeters, 1970. "The Full Employment Surplus Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 1(1), pages 77-116.
  5. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Working Papers 6570, National Bureau of Economic Research, Inc.
  6. Robert E. Hall, 1970. "Why Is the Unemployment Rate So High at Full Employment?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 1(3), pages 369-410.
  7. Julio J. Rotemberg, 1999. "A Heuristic Method for Extracting Smooth Trends from Economic Time Series," NBER Working Papers 7439, National Bureau of Economic Research, Inc.
  8. Bennett T. McCallum, 2001. "Should Monetary Policy Respond Strongly to Output Gaps?," NBER Working Papers 8226, National Bureau of Economic Research, Inc.
  9. Laurence Ball & N. Gregory Mankiw, 2002. "The NAIRU in Theory and Practice," Harvard Institute of Economic Research Working Papers 1963, Harvard - Institute of Economic Research.
  10. Athanasios Orphanides & Simon van Norden, 2004. "The reliability of inflation forecasts based on output gap estimates in real time," Finance and Economics Discussion Series 2004-68, Board of Governors of the Federal Reserve System (U.S.).
  11. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Finance and Economics Discussion Series 93-17, Board of Governors of the Federal Reserve System (U.S.).
  12. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
  13. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  14. Kevin J. Lansing, 2002. "Real-time estimation of trend output and the illusion of interest rate smoothing," Economic Review, Federal Reserve Bank of San Francisco, pages 17-34.
  15. Victor Zarnowitz & Phillip Braun, 1992. "Twenty-two Years of the NBER-ASA Quarterly Economic Outlook Surveys: Aspects and Comparisons of Forecasting Performance," NBER Working Papers 3965, National Bureau of Economic Research, Inc.
  16. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
  17. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  18. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," International Tax and Public Finance, Springer, vol. 6(4), pages 537-577, November.
  19. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
  20. Antulio N. Bomfim, 2001. "Measuring equilibrium real interest rates: what can we learn from yields on indexed bonds?," Finance and Economics Discussion Series 2001-53, Board of Governors of the Federal Reserve System (U.S.).
  21. Douglas O. Staiger & James H. Stock & Mark W. Watson, 1997. "How Precise Are Estimates of the Natural Rate of Unemployment?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 195-246 National Bureau of Economic Research, Inc.
  22. Glenn D. Rudebusch, 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal, Royal Economic Society, vol. 112(479), pages 402-432, April.
  23. Coenen Günter & Orphanides Athanasios & Wieland Volker, 2004. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-25, February.
  24. Nelson, Edward & Nikolov, Kalin, 2003. "UK inflation in the 1970s and 1980s: the role of output gap mismeasurement," Journal of Economics and Business, Elsevier, vol. 55(4), pages 353-370.
  25. Thomas Laubach & John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics, MIT Press, vol. 85(4), pages 1063-1070, November.
  26. Orphanides, Athanasios, 1999. "The Quest for Prosperity Without Inflation," Working Paper Series 93, Sveriges Riksbank (Central Bank of Sweden).
  27. Athanasios Orphanides, 2000. "Activist stabilization policy and inflation: the Taylor rule in the 1970s," Finance and Economics Discussion Series 2000-13, Board of Governors of the Federal Reserve System (U.S.).
  28. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
  29. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  30. Ehrmann, Michael & Smets, Frank, 2001. "Uncertain potential output: implications for monetary policy," Working Paper Series 0059, European Central Bank.
  31. George A. Akerlof & William R. Dickens & George L. Perry, 1996. "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1), pages 1-76.
  32. Neiss, Katharine S. & Nelson, Edward, 2003. "The Real-Interest-Rate Gap As An Inflation Indicator," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 239-262, April.
  33. Franco Modigliani & Lucas Papademos, 1975. "Targets for Monetary Policy in the Coming Year," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 141-166.
  34. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  35. Frank Smets, 1998. "Output gap uncertainty: does it matter for the Taylor rule?," BIS Working Papers 60, Bank for International Settlements.
  36. Lawrence J. Christiano & Terry J. Fitzgerald, 1999. "The Band pass filter," Working Paper 9906, Federal Reserve Bank of Cleveland.
    • Lawrence J. Christiano & Terry J. Fitzgerald, 2003. "The Band Pass Filter," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(2), pages 435-465, 05.
  37. Thomas Laubach, 1997. "Measuring the NAIRU : evidence from seven economies," Research Working Paper 97-13, Federal Reserve Bank of Kansas City.
  38. Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  39. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  40. Andrew G. Haldane & Nicoletta Batini, 1998. "Forward-Looking Rules for Monetary Policy," NBER Working Papers 6543, National Bureau of Economic Research, Inc.
  41. Robert J. Hodrick & Edward Prescott, 1981. "Post-War U.S. Business Cycles: An Empirical Investigation," Discussion Papers 451, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  42. Leitemo, Kai & Lonning, Ingunn, 2006. "Simple Monetary Policymaking without the Output Gap," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1619-1640, September.
  43. Nelson, Edward & Nikolov, Kalin, 2004. "Monetary Policy and Stagflation in the UK," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 293-318, June.
  44. St-Amant, P. & van Norden, S., 1997. "Measurement of the Output Gap: A Discussion of Recent Research at the Bank of Canada," Technical Reports 79, Bank of Canada.
  45. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  46. Athanasios Orphanides & Simon van Norden, 1999. "The reliability of output gap estimates in real time," Finance and Economics Discussion Series 1999-38, Board of Governors of the Federal Reserve System (U.S.).
  47. Laurence Ball & Robert Tchaidze, 2002. "The Fed and the New Economy," NBER Working Papers 8785, National Bureau of Economic Research, Inc.
  48. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
  49. Bomfim, Antulio N, 1997. "The Equilibrium Fed Funds Rate and the Indicator Properties of Term-Structure Spreads," Economic Inquiry, Western Economic Association International, vol. 35(4), pages 830-46, October.
  50. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  51. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, vol. 17(3), pages 247-252.
  52. Fuhrer, Jeffrey C & Moore, George R, 1995. "Forward-Looking Behavior and the Stability of a Conventional Monetary Policy Rule," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1060-70, November.
  53. Carl Walsh, 2001. "Speed Limit Policies: The Output Gap and Optimal Monetary Policy," CESifo Working Paper Series 609, CESifo Group Munich.
  54. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
  55. Orphanides, Athanasios & Porter, Richard D. & Reifschneider, David & Tetlow, Robert & Finan, Frederico, 2000. "Errors in the measurement of the output gap and the design of monetary policy," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 117-141.
  56. Smets, Frank, 2000. "What horizon for price stability," Working Paper Series 0024, European Central Bank.
  57. Laurence H. Meyer & Eric T. Swanson & Volker W. Wieland, 2001. "NAIRU uncertainty and nonlinear policy rules," Finance and Economics Discussion Series 2001-01, Board of Governors of the Federal Reserve System (U.S.).
  58. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
  59. George L. Perry, 1970. "Changing Labor Markets and Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 1(3), pages 411-448.
  60. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
  61. Athanasios Orphanides, 1998. "Monetary policy evaluation with noisy information," Finance and Economics Discussion Series 1998-50, Board of Governors of the Federal Reserve System (U.S.).
  62. Sargent, Thomas J, 1971. "A Note on the 'Accelerationist' Controversy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 3(3), pages 721-25, August.
  63. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  64. John P. Judd & Brian Motley, 1992. "Controlling inflation with an interest rate instrument," Economic Review, Federal Reserve Bank of San Francisco, pages 3-22.
  65. William Poole, 1971. "Alternative Paths to a Stable Full Employment Economy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 2(3), pages 579-614.
  66. Marianne Baxter & Robert G. King, 1995. "Measuring Business Cycles Approximate Band-Pass Filters for Economic Time Series," NBER Working Papers 5022, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:bin:bpeajo:v:33:y:2002:i:2002-2:p:63-146. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Eric Encarnacion).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.