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Monetary Policy with Judgement: Forecast Targeting

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  • Svensson, Lars E O

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 US 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5072.

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Date of creation: May 2005
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Handle: RePEc:cpr:ceprdp:5072

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Keywords: forecasts; inflation targeting; optimal monetary policy;

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