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Empirical and policy performance of a forward-looking monetary model

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Author Info
Alexei Onatski
Noah Williams

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Abstract

In this paper we consider the policy implications of a fully specified dynamic general equilibrium model, developed by Smets and Wouters (2003a). This is a relatively large-scale forward looking model, which was shown to provide a good fit to the data. However there has been little previous work analyzing monetary policy within such a model. We first re-examine the empirical performance of the model. We show that systematically accounting for prior uncertainty leads to substantially different parameter estimates. However many of the qualitative features of the model remain similar under the alternative estimates that we find. We then formulate and analyze optimal policy rules in the model. In addition a standard, but ad hoc, loss function we derive and justify a utility-based loss function for the model. We determine the optimal equilibrium dynamics under both loss functions and under both sets of parameter estimates. Then we discuss alternative ways of implementing the optimal equilibrium. We find that there is much scope for indeterminacy in the model, and that optimal policy rules developed for one set of estimates may perform poorly if the economy is governed by the other set. We finally turn to the analysis of simple policy rules, finding that for the simple loss function these rules perform relatively well and are robust to different parameter estimates. Overall, our results suggest that the model may be relatively robust in its ability to capture certain aspects of the data. However some caution should be exercised in using the structural estimates, and in particular it may be dangerous to pursue fully optimal policy in such complex models.

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

Volume (Year): (2004)
Issue (Month): Mar ()
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Handle: RePEc:fip:fedfpr:y:2004:i:mar:x:6

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Keywords: Interest rates ; Monetary policy;

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References listed on IDEAS
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  2. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April. [Downloadable!] (restricted)
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  3. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July. [Downloadable!] (restricted)
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  4. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September. [Downloadable!] (restricted)
  5. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics. [Downloadable!]
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  6. John C. Williams, 2003. "Simple rules for monetary policy," Economic Review, Federal Reserve Bank of San Francisco, pages 1-12. [Downloadable!]
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  7. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June. [Downloadable!] (restricted)
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  9. James H. Stock & Mark W. Watson, 2003. "Has the business cycle changed?," Proceedings, Federal Reserve Bank of Kansas City, pages 9-56. [Downloadable!]
  10. 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. [Downloadable!] (restricted)
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  11. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Svensson, Lars E. O. & Woodford, Michael, 2003. "Indicator variables for optimal policy," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 691-720, April. [Downloadable!] (restricted)
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  13. Smets, Frank & Wouters, Rafael, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," CEPR Discussion Papers 6112, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  14. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October. [Downloadable!] (restricted)
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  15. Jeffery D. Amato & Thomas Laubach, 2002. "Implications of habit formation for optimal monetary policy," BIS Working Papers 121, Bank for International Settlements. [Downloadable!]
  16. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, 09. [Downloadable!] (restricted)
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  17. Backus, David & Driffill, John, 1986. "The Consistency of Optimal Policy in Stochastic Rational Expectations Models," CEPR Discussion Papers 124, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  20. Gabriel Fagan & Jérôme Henry & Ricardo Mestre, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 42, European Central Bank. [Downloadable!]
  21. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  22. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
  23. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc. [Downloadable!]
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  26. repec:cup:cbooks:9780521441964 is not listed on IDEAS
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