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Monetary Policy with Judgment: Forecast Targeting

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  • Lars E O Svensson

    (Princeton University)

Abstract

"Forecast targeting", forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the U.S. economy, one forward looking and one backward looking. A complicated infinite-horizon central-bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank’s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 1 (2005)
Issue (Month): 1 (May)
Pages:

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Handle: RePEc:ijc:ijcjou:y:2005:q:2:a:1

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  1. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
  2. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
  3. Reifschneider, David L. & Stockton, David J. & Wilcox, David W., 1997. "Econometric models and the monetary policy process," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 1-37, December.
  4. Currie,David & Levine,Paul, 1993. "Rules, Reputation and Macroeconomic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521441964.
  5. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  6. Bennett T. McCallum & Edward Nelson, 2004. "Targeting vs. instrument rules for monetary policy," Working Papers 2004-011, Federal Reserve Bank of St. Louis.
  7. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  8. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  9. Albert Marcet & Ramon Marimon, 2011. "Recursive Contracts," Economics Working Papers ECO2011/15, European University Institute.
  10. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  11. 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.
  12. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
  13. Bennett T. McCallum & Edward Nelson, 2005. "Targeting versus instrument rules for monetary policy," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 225-245.
  14. Lars O. Svensson & Robert J. Tetlow, 2005. "Optimal Policy Projections," NBER Working Papers 11392, National Bureau of Economic Research, Inc.
  15. 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.
  16. Jon Faust & Dale W. Henderson, 2004. "Is inflation targeting best-practice monetary policy?," International Finance Discussion Papers 807, Board of Governors of the Federal Reserve System (U.S.).
  17. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator variables for optimal policy," Proceedings, Federal Reserve Bank of San Francisco.
  18. Christopher A. Sims, 2002. "The Role of Models and Probabilities in the Monetary Policy Process," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 33(2), pages 1-62.
  19. Glenn D. Rudebusch, 1990. "Trends and random walks in macroeconomic time series: a re-examination," Working Paper Series / Economic Activity Section 105, Board of Governors of the Federal Reserve System (U.S.).
  20. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
  21. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  22. 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.
  23. Walsh, Carl E, 2004. "Robustly Optimal Instrument Rules and Robust Control: An Equivalence Result," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(6), pages 1105-13, December.
  24. Lars E.O. Svensson & Kjetil Houg & Haakon O.Aa. Solheim & Erling Steigum, 2002. "An Independent Review of Monetary Policy and Institutions in Norway," Working Papers 120, Princeton University, Department of Economics, Center for Economic Policy Studies..
  25. Alan Greenspan, 2004. "Risk and Uncertainty in Monetary Policy," American Economic Review, American Economic Association, vol. 94(2), pages 33-40, May.
  26. Lars E.O. Svensson, 2004. "Targeting Rules vs. Instrument Rules for Monetary Policy: What is Wrong with McCallum and Nelson?," NBER Working Papers 10747, National Bureau of Economic Research, Inc.
  27. Sharon Kozicki, 1999. "How useful are Taylor rules for monetary policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-33.
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