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Monetary policy and self-fulfilling expectations: the danger of forecasts

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  • Charles T. Carlstrom
  • Timothy S. Fuerst

Abstract

What rule should a central bank interested in inflation stability follow? Because monetary policy tends to work with lags, it is tempting to use inflation forecasts to generate policy advice. This article, however, suggests that the use of forecasts to drive policy is potentially destabilizing. The problem with forecast-based policy is that the economy becomes vulnerable to what economists term “sunspot” fluctuations. These welfare-reducing fluctuations can be avoided by using a policy that puts greater weight on past, realized inflation rates rather than forecasted, future rates.

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Bibliographic Info

Article provided by Federal Reserve Bank of Cleveland in its journal Economic Review.

Volume (Year): (2001)
Issue (Month): Q I ()
Pages: 9-19

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Handle: RePEc:fip:fedcer:y:2001:i:qi:p:9-19

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Keywords: Monetary policy ; Inflation (Finance) ; Forecasting;

References

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  1. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1999. "Monetary Policy and Multiple Equilibria," Departmental Working Papers 199914, Rutgers University, Department of Economics.
  2. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, December.
  3. Woodford, Michael, 1990. "Learning to Believe in Sunspots," Econometrica, Econometric Society, vol. 58(2), pages 277-307, March.
  4. Christian Gilles & Pamela A. Labadie & Wilbur John Coleman II., 1996. "A model of the federal funds market," Economic Theory, Springer, vol. 7(2), pages 337-357.
  5. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  6. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
  7. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "Monetary policy rules and macroeconomic stability: Evidence and some theory," Economics Working Papers 350, Department of Economics and Business, Universitat Pompeu Fabra, revised May 1999.
  8. Carlstrom, Charles T. & Fuerst, Timothy S., 1995. "Interest rate rules vs. money growth rules a welfare comparison in a cash-in-advance economy," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 247-267, November.
  9. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
  10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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Citations

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Cited by:
  1. Ibrahim Chowdhury & Andreas Schabert, . "Assessing Money Supply Rules," Working Papers 2003_9, Business School - Economics, University of Glasgow, revised May 2003.
  2. Bordes, C. & Clerc, L., 2004. "Price Stability and The ECB's Monetary Policy Strategy," Working papers 109, Banque de France.
  3. repec:hal:cesptp:hal-00308557 is not listed on IDEAS
  4. Keen Meng Choy & Kenneth Leong & Anthony S. Tay, 2003. "Non-Fundamental Expectations and Economic Fluctuations: Evidence from Professional Forecasts," Departmental Working Papers wp0306, National University of Singapore, Department of Economics.
  5. Loisel, O., 2006. "Bubble-free interest-rate rules," Working papers 161, Banque de France.

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