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Endogenous monetary policy with unobserved potential output

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Author Info
Alex Cukierman (Tel-Aviv University and Center, Tilburg University)
Francesco Lippi () (Banca d'Italia)

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Abstract

This paper characterizes endogenous monetary policy when policymakers are uncertain about the extent to which movements in output and inflation are due to changes in potential output or to cyclical demand and cost shocks. We refer to this informational limitation as the “information problem” (IP). Main results of the paper are: 1. Policy is likely to be excessively loose (restrictive) for some time when there is a large decrease (increase) in potential output in comparison with a full information benchmark. 2. Errors in forecasting potential output and the output gap are generally serially correlated. These ndings provide a partial explanation for the inflation of the seventies and the price stability of the nineties. 3. A quantitative assessment, based on an empirical model of the US economy developed by Rudebusch and Svensson (1999), indicates that during and following periods of large changes in potential output the IP significantly affects the dynamics of inflation and output. 4. The increase in the Fed’s conservativeness between the seventies and the nineties, and a more realistic appreciation of the uncertainties surrounding potential output in the second period, imply that the IP problem had a stronger impact in the seventies than in the nineties.

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Paper provided by Bank of Italy, Economic Research Department in its series Temi di discussione (Economic working papers) with number 493.

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Date of creation: Jun 2004
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Handle: RePEc:bdi:wptemi:td_493_04

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Related research
Keywords: monetary policy; potential output; filtering; inflation; output gap;

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Find related papers by JEL classification:
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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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. Kevin J. Lansing, 2002. "Learning about a shift in trend output: implications for monetary policy and inflation," Working Papers in Applied Economic Theory 2000-16, Federal Reserve Bank of San Francisco. [Downloadable!]
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  2. Kuttner, Kenneth N, 1994. "Estimating Potential Output as a Latent Variable," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 361-68, July.
  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. Gerali, Andrea & Lippi, Francesco, 2003. "Optimal Control and Filtering in Linear Forward-looking Economies: A Toolkit," CEPR Discussion Papers 3706, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  5. Athanasios Orphanides, 2000. "The quest for prosperity without inflation," Working Paper Series 15, European Central Bank. [Downloadable!]
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  6. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  7. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  8. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1.
  9. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies. [Downloadable!]
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  10. Lars Peter Hansen & Thomas J. Sargent, 1990. "Recursive Linear Models of Dynamic Economies," NBER Working Papers 3479, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June. [Downloadable!] (restricted)
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  12. Staiger, Douglas & Stock, James H & Watson, Mark W, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter. [Downloadable!] (restricted)
  13. Kenneth Kuttner, 1992. "Monetary policy with uncertain estimates of potential output," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jan, pages 2-15. [Downloadable!]
  14. Ehrmann, M. & Smets, F., 2001. "Uncertain Potential Output: Implications for Monetary Policy," Papers 59, Quebec a Montreal - Recherche en gestion.
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  15. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June. [Downloadable!] (restricted)
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  16. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  17. Blanchard, Olivier Jean & Quah, Danny, 1989. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," American Economic Review, American Economic Association, vol. 79(4), pages 655-73, September. [Downloadable!] (restricted)
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  18. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  19. Brunner, Karl & Cukierman, Alex & Meltzer, Allan H., 1980. "Stagflation, persistent unemployment and the permanence of economic shocks," Journal of Monetary Economics, Elsevier, vol. 6(4), pages 467-492, October. [Downloadable!] (restricted)
  20. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  21. Eric T. Swanson, 2000. "On signal extraction and non-certainty-equivalence in optimal monetary policy rules," Finance and Economics Discussion Series 2000-32, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  22. Taylor, J.B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by European Central Bank," Papers 649, Stockholm - International Economic Studies.
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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. Alex Cukierman, 2006. "Central Bank Independence and Monetary Policymaking Institutions: Past, Present, and Future," Working Papers Central Bank of Chile 360, Central Bank of Chile. [Downloadable!]
    Other versions:
  2. Fabrice Collard & Harris Dellas, 2004. "The great inflation of the 1970s," Working Paper Series 336, European Central Bank. [Downloadable!]
    Other versions:
  3. Athanasios Orphanides & John C. Williams, 2008. "Imperfect Knowledge And The Pitfalls Of Optimal Control Monetary Policy," Working Papers Central Bank of Chile 499, Central Bank of Chile. [Downloadable!]
    Other versions:
  4. Francesco Spadafora, 2004. "Il pilastro privato del sistema previdenziale. Il caso del Regno Unito," Temi di discussione (Economic working papers) 503, Bank of Italy, Economic Research Department. [Downloadable!]
  5. John C. Williams & Athanasios Orphanides, 2004. "The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations," Computing in Economics and Finance 2004 144, Society for Computational Economics. [Downloadable!]
    Other versions:
  6. Athanasios Orphanides & John C. Williams, 2006. "Inflation Targeting Under Imperfect Knowledge," Working Papers Central Bank of Chile 398, Central Bank of Chile. [Downloadable!]
    Other versions:
  7. Paolo Finaldi Russo & Luigi Leva, 2004. "Il debito commerciale in Italia: quanto contano le motivazioni finanziarie?," Temi di discussione (Economic working papers) 496, Bank of Italy, Economic Research Department. [Downloadable!]
  8. Frederic S. Mishkin & Klaus Schmidt-Hebbel, 2006. "Monetary Policy Under Inflation Targeting: An Introduction," Working Papers Central Bank of Chile 396, Central Bank of Chile. [Downloadable!]
    Other versions:
  9. James B. Bullard & Stefano Eusepi, 2004. "Did the Great Inflation occur despite policymaker commitment to a Taylor rule?," Working Papers 2003-013, Federal Reserve Bank of St. Louis. [Downloadable!]
    Other versions:
  10. Gerberding, Christina & Worms, Andreas & Seitz, Franz, 2004. "How the Bundesbank really conducted monetary policy : An analysis based on real-time data," Discussion Paper Series 1: Economic Studies 2004,25, Deutsche Bundesbank, Research Centre. [Downloadable!]
  11. Athanasios Orphanides & John C. Williams, 2007. "Robust monetary policy with imperfect knowledge," Finance and Economics Discussion Series 2007-33, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  12. Simona Delle Chiaie, 2007. "Monetary Policy and Potential Output Uncertainty: A Quantitative Assessment," CEIS Research Paper 94, Tor Vergata University, CEIS. [Downloadable!]
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