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A defense of moderation in monetary policy

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  • Williams, John C.

Abstract

This paper examines the implications of uncertainty about the effects of monetary policy for optimal monetary policy with an application to the current situation. Using a stylized macroeconomic model, I derive optimal policies under uncertainty for both conventional and unconventional monetary policies. According to an estimated version of this model, the US economy is currently suffering from a large and persistent adverse demand shock. Optimal monetary policy absent uncertainty would quickly restore real GDP close to its potential level and allow the inflation rate to rise temporarily above the longer-run target. By contrast, the optimal policy under uncertainty is more muted in its response. As a result, output and inflation return to target levels only gradually. This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Second, one cannot simply look at point forecasts and judge whether policy is optimal. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument associated with the least uncertainty and use alternative, more uncertain instruments only when the least uncertain instrument is employed to its fullest extent possible.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 38 (2013)
Issue (Month): PB ()
Pages: 137-150

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Handle: RePEc:eee:jmacro:v:38:y:2013:i:pb:p:137-150

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Web page: http://www.elsevier.com/locate/inca/622617

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Keywords: Optimal monetary policy; Uncertainty; Bayesian decision making; Unconventional monetary policy;

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  1. John C. Williams, 2011. "Unconventional monetary policy: lessons from the past three years," Speech 92, Federal Reserve Bank of San Francisco.
  2. Glenn D. Rudebusch & John C. Williams, 2006. "Revealing the secrets of the temple: the value of publishing central bank interest rate projections," Working Paper Series 2006-31, Federal Reserve Bank of San Francisco.
  3. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  4. Wieland, Volker, 1999. "Monetary policy, parameter uncertainty and optimal learning," ZEI Working Papers B 09-1999, ZEI - Center for European Integration Studies, University of Bonn.
  5. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2007. "Welfare-maximizing monetary policy under parameter uncertainty," Proceedings, Federal Reserve Bank of San Francisco.
  6. John C. Williams, 2012. "The Federal Reserve's unconventional policies," Speech 113, Federal Reserve Bank of San Francisco.
  7. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
  8. Michael T. Kiley, 2012. "The aggregate demand effects of short- and long-term interest rates," Finance and Economics Discussion Series 2012-54, Board of Governors of the Federal Reserve System (U.S.).
  9. Athanasios Orphanides amd John Williams, 2001. "Monetary Policy with Imperfect Knowledge," Computing in Economics and Finance 2001 254, Society for Computational Economics.
  10. David Reifschneider & John C. Williams, 1999. "Three lessons for monetary policy in a low inflation era," Finance and Economics Discussion Series 1999-44, Board of Governors of the Federal Reserve System (U.S.).
  11. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  12. Söderström, Ulf, 1999. "Monetary policy with uncertain parameters," Working Paper Series in Economics and Finance 308, Stockholm School of Economics.
  13. John C. Williams & Andrew T. Levin, 2003. "Parameter Uncertainty and the Central Bank's Objective Function," Computing in Economics and Finance 2003 215, Society for Computational Economics.
  14. Lars E. O. Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc.
  15. Han Chen & Vasco Cúrdia & Andrea Ferrero, 2012. "The Macroeconomic Effects of Large‐scale Asset Purchase Programmes," Economic Journal, Royal Economic Society, vol. 122(564), pages F289-F315, November.
  16. Glenn D. Rudebusch, 2001. "Is The Fed Too Timid? Monetary Policy In An Uncertain World," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 203-217, May.
  17. John C. Williams, 2003. "Simple rules for monetary policy," Economic Review, Federal Reserve Bank of San Francisco, pages 1-12.
  18. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
  19. Baumeister, Christiane & Benati, Luca, 2010. "Unconventional monetary policy and the great recession - Estimating the impact of a compression in the yield spread at the zero lower bound," Working Paper Series 1258, European Central Bank.
  20. Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
  21. 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.
  22. Canlin Li & Min Wei, 2013. "Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Progarms," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 3-39, March.
  23. Woodford, Michael, 2013. "Forward Guidance by Inflation-Targeting Central Banks," CEPR Discussion Papers 9722, C.E.P.R. Discussion Papers.
  24. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
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