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Monetary Policy Rules under Heterogeneous Inflation Expectations

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  • Sophocles N. Brissimis

    ()
    (Bank of Greece, Economic Research Department and University of Piraeus)

  • Nicholas S. Magginas

    (National Bank of Greece)

Abstract

This paper evaluates the role of inflation-forecast heterogeneity in US monetary policy making. The deviation between private and central bank inflation forecasts is identified as a factor increasing inflation persistence and thus calling for a policy reaction. An optimal policy rule is derived by the minimization under discretion of a standard central bank loss function subject to a Phillips curve, modified to include the forecast deviation, and a forward-looking aggregate demand equation. This rule, which itself includes the forecast deviation as an additional argument, is estimated for the period 1974-1998, covering the Chairmanships of Arthur Burns, Paul Volcker and Alan Greenspan, by using real-time forecasts of inflation and the output gap obtained from the FOMC’s Greenbook and the Survey of Professional Forecasters. The estimated rule remains remarkably stable over the whole sample period, challenging the conventional view of a structural break following Volcker’s appointment as Chairman of the Fed. Finally, the substantial decline in the significance of the interest-rate smoothing term in the rule indicates that monetary policy inertia may, to a large extent, be an artifact of serially correlated inflation-forecast errors that feed into policy decisions in real time.

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Bibliographic Info

Paper provided by Bank of Greece in its series Working Papers with number 35.

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Length: 38 pages
Date of creation: Mar 2006
Date of revision:
Handle: RePEc:bog:wpaper:35

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Web page: http://www.bankofgreece.gr
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Related research

Keywords: Forward-looking model; Monetary policy reaction function; Expectations formation; Inflation expectations;

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References

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  1. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  2. 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.
  3. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  4. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
  5. John M. Roberts, 1998. "Inflation expectations and the transmission of monetary policy," Finance and Economics Discussion Series 1998-43, Board of Governors of the Federal Reserve System (U.S.).
  6. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.).
  7. 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.
  8. 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.).
  9. Mankiw, N. Gregory & Reis, Ricardo, 2002. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Scholarly Articles 3415324, Harvard University Department of Economics.
  10. Athanasios Orphanides & John C. Williams, 2003. "Inflation scares and forecast-based monetary policy," Finance and Economics Discussion Series 2003-41, Board of Governors of the Federal Reserve System (U.S.).
  11. Bernanke, Ben S. & Boivin, Jean, 2003. "Monetary policy in a data-rich environment," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 525-546, April.
  12. Athanasios Orphanides, 2002. "Monetary-Policy Rules and the Great Inflation," American Economic Review, American Economic Association, vol. 92(2), pages 115-120, May.
  13. Francesco Lippi & Stefano Neri, 2004. "Information variables for monetary policy in a small structural model of the euro area," Temi di discussione (Economic working papers) 511, Bank of Italy, Economic Research and International Relations Area.
  14. Sophocles N. Brissimis & Nicholas S. Magginas, 2004. "Forward-Looking Information in VAR Models and the Price Puzzle," Working Papers 10, Bank of Greece.
  15. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  16. Honkapohja, Seppo & Evans, George W., 2000. "Expectations and the stability problem for optimal monetary policies," Discussion Paper Series 1: Economic Studies 2000,10, Deutsche Bundesbank, Research Centre.
  17. Orphanides, Athanasios, 2004. "Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(2), pages 151-75, April.
  18. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  19. Christopher D Carroll, 2002. "Macroeconomic Expectations of Households and Professional Forecasters," Economics Working Paper Archive 477, The Johns Hopkins University,Department of Economics.
  20. Perez, Stephen J., 2001. "Looking back at forward-looking monetary policy," Journal of Economics and Business, Elsevier, vol. 53(5), pages 509-521.
  21. repec:nbr:nberre:0126 is not listed on IDEAS
  22. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
  23. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  24. Orlando Gomes, 2004. "Optimal Monetary Policy under Heterogeneous Expectations," Macroeconomics 0409023, EconWPA.
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Citations

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Cited by:
  1. Hans Genberg, 2006. "Exchange-Rate Arrangements and Financial Integration in East Asia: On a Collision Course?," Working Papers 152006, Hong Kong Institute for Monetary Research.
  2. John Williamson, 2006. "A Worldwide System of Reference Rates," Working Papers 45, Bank of Greece.
  3. Alexandros E. Milionis, 2006. "An Alternative Definition of Market Efficiency and some Comments on its Empirical Testing," Working Papers 50, Bank of Greece.
  4. Otmar Issing, 2006. "Europe's Hard Fix: The Euro Area," Working Papers 39, Bank of Greece.

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