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On signal extraction and non-certainty-equivalence in optimal monetary policy rules

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Eric T. Swanson

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Abstract

A standard result in the literature on monetary policy rules is that of certainty equivalence: given the expected values of all the state variables of the economy, policy should be set in a way that is independent of all higher moments of those variables. Some exceptions to this rule have been pointed out by Smets (1998), who restricts policy to respond to only a limited subset of state variables, and by Orphanides (1998), who restricts policy to respond to estimates of the state variables that are biased. In contrast, this paper studies unrestricted, fully optimal policy rules with optimal estimation of state variables. The rules in this framework exhibit certainty equivalence with respect to estimates of an unobserved, possibly complicated, state of the economy X, but are not certainty-equivalent when 1) a signal-extraction problem is involved in the estimation of X, and 2) the optimal rule is expressed as a reduced form that combines policymakers' estimation and policy-setting stages. In general, I show that it is optimal for policymakers to attenuate their reaction coefficient on a variable about which uncertainty has increased, while responding more aggressively to all other variables, about which uncertainty hasn't changed.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2000)
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Handle: RePEc:fip:fedfpr:y:2000:x:5

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Keywords: Monetary policy Forecasting

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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.:
  1. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Orphanides, Athanasios, 1999. "The Quest for Prosperity Without Inflation," Working Paper Series 93, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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  3. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator Variables for Optimal Policy," NBER Working Papers 7953, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Drew, Aaron & Hunt, Benjamin, 2000. "Efficient simple policy rules and the implications of potential output uncertainty," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 143-160. [Downloadable!] (restricted)
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  5. Glenn Rudebusch, 2000. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Econometric Society World Congress 2000 Contributed Papers 0065, Econometric Society. [Downloadable!]
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  6. Stephen K. McNees, 1995. "Assessment of the "official" economic forecasts," New England Economic Review, Federal Reserve Bank of Boston, issue Jul, pages 13-23. [Downloadable!]
  7. Frank Smets, 2002. "Output gap uncertainty: Does it matter for the Taylor rule?," Empirical Economics, Springer, vol. 27(1), pages 113-129. [Downloadable!] (restricted)
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  8. Athanasios Orphanides & Richard D. Porter & David Reifschneider & Robert Tetlow & Frederico Finan, 1999. "Errors in the measurement of the output gap and the design of monetary policy," Finance and Economics Discussion Series 1999-45, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39, pages 195-214, December. [Downloadable!] (restricted)
  10. 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.). [Downloadable!]
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  11. N. Gregory Mankiw & Matthew D. Shapiro, 1986. "News or Noise? An Analysis of GNP Revisions," NBER Working Papers 1939, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. 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. [Downloadable!] (restricted)
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  13. Volker Wieland, 1998. "Monetary policy and uncertainty about the natural unemployment rate," Finance and Economics Discussion Series 1998-22, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  14. Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
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Cited by:
(explanations, 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.)

  1. Christophe Planas & Alessandro Rossi, 2004. "Can inflation data improve the real-time reliability of output gap estimates?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 19(1), pages 121-133. [Downloadable!]
  2. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Michael Ehrmann & Frank Smets, 2001. "Uncertain potential output: implications for monetary policy," Working Paper Series 059, European Central Bank. [Downloadable!]
    Other versions:
  4. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies. [Downloadable!]
    Other versions:
  5. 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.). [Downloadable!]
    Other versions:
  6. Andreas Hornstein & Michael Dotsey, 2002. "Should optimal discretionary monetary policy look at money?," Working Paper 02-04, Federal Reserve Bank of Richmond. [Downloadable!]
  7. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator Variables for Optimal Policy," NBER Working Papers 7953, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  8. Cukierman, Alex & Lippi, Francesco, 2003. "Endogenous Monetary Policy with Unobserved Potential Output," CEPR Discussion Papers 3763, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  9. Gabriel Srour, 2003. "Some Notes on Monetary Policy Rules with Uncertainty," Working Papers 03-16, Bank of Canada. [Downloadable!]
  10. Christopher Martin & Costas Milas, 2004. "Uncertainty and UK Monetary Policy," City University Economics Discussion Papers 04/05, Department of Economics, City University, London. [Downloadable!]
    Other versions:
  11. James Hamilton, 2000. "Indicator variables for optimal policy, comments," Proceedings, Federal Reserve Bank of San Francisco. [Downloadable!]
  12. Jean-Philippe Cayen & Simon van Norden, 2002. "La fiabilité des estimations de l'écart de production au Canada," Working Papers 02-10, Bank of Canada. [Downloadable!]
  13. Athanasios Orphanides & John C. Williams, 2002. "Robust monetary policy rules with unknown natural rates," Working Papers in Applied Economic Theory 2003-01, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  14. Aoki, Kosuke, 2002. "Optimal Commitment Policy Under Noisy Information," CEPR Discussion Papers 3370, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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