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Rethinking the Role of NAIRU in Monetary Policy: Implications of Model Formulation and Uncertainty

In: Monetary Policy Rules

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  • Arturo Estrella
  • Frederic S. Mishkin

Abstract

In this paper we rethink the NAIRU concept and examine whether it might have a useful role in monetary policy. We argue that it can, but success depends critically on defining NAIRU as a short-run concept and distinguishing it from a long-run concept like the natural rate of unemployment. We examine what effect uncertainty has on the use of NAIRU in policy. Uncertainty about the level of NAIRU does not imply that monetary policy should react less to the NAIRU gap. However, uncertainty about the effect of the NAIRU gap on inflation does require adjustments to the policy reaction function. Also, as in Brainard (1967), uncertainty about the effect of the monetary policy instrument on the NAIRU gap reduces the magnitude of the policy response. We estimate a simple NAIRU gap model for the United States to obtain quantitative measures of uncertainty and to assess how these measures affect our view of the policy reaction function.

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This chapter was published in:

  • John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, October.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 7421.

    Handle: RePEc:nbr:nberch:7421

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    1. Franco Modigliani & Lucas Papademos, 1975. "Targets for Monetary Policy in the Coming Year," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 141-166.
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    4. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CEPR Discussion Papers 3811, C.E.P.R. Discussion Papers.
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    11. Douglas O. Staiger & James H. Stock & Mark W. Watson, 1997. "How Precise Are Estimates of the Natural Rate of Unemployment?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 195-246 National Bureau of Economic Research, Inc.
    12. Joseph Stiglitz, 1997. "Reflections on the Natural Rate Hypothesis," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 3-10, Winter.
    13. Layard, R. & Bean, C., 1988. "Why Does Unemployment Persist?," Papers 321, London School of Economics - Centre for Labour Economics.
    14. Marco A. Espinosa-Vega & Steven Russell, 1997. "History and theory of the NAIRU: a critical review," Economic Review, Federal Reserve Bank of Atlanta, issue Q 2, pages 4-25.
    15. Edmund S. Phelps, 1968. "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 76, pages 678.
    16. Arturo Estrella, 1997. "Aggregate supply and demand shocks: a natural rate approach," Research Paper 9739, Federal Reserve Bank of New York.
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