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Optimal Monetary Policy using a VAR

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  • Polito, Vito
  • Wickens, Michael R

Abstract

In this paper we propose a new way to formulate optimal policy based on a quadratic intertemporal welfare function where the dynamic constraint is based on a VAR model of the economy which we call the PVAR method. We argue that the VAR under control should not be derived simply by replacing the VAR equation for the policy instruments by an optimal control rule because this alters the stochastic structure of the VAR. Instead, one should first transform the VAR in order to condition the non-policy variables on the policy instruments, then use the resulting sub-system as the dynamic constraint, and finally construct the VAR under control by combining this sub-system with the resulting optimal policy rule. In this way the original stochastic structure of the VAR is retained. In comparing the two approaches we explain the theoretical advantages of the PVAR over the standard method and we illustrate the methods by examining the formulation of optimal monetary policy for the US. We suggest that since the whole process is easily automated, the PVAR method may provide a useful benchmark for use in real time against which to compare other, probably far more labour intensive, policy choices.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6957.

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Date of creation: Sep 2008
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Handle: RePEc:cpr:ceprdp:6957

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Keywords: monetary policy; optimal control; VAR models;

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References

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  1. Glenn D. Rudebusch, 2002. "Assessing the Lucas critique in monetary policy models," Working Paper Series 2002-02, Federal Reserve Bank of San Francisco.
  2. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
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Citations

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Cited by:
  1. Jasper Lukkezen & Coen Teulings, 2013. "Optimal fiscal policy," CPB Discussion Paper 242, CPB Netherlands Bureau for Economic Policy Analysis.
  2. Hubert Gabrisch & Lucjan T Orlowski, 2011. "Extreme Risks in Financial Markets and Monetary Policies of the Euro-Candidates," Comparative Economic Studies, Palgrave Macmillan, vol. 53(4), pages 511-534, December.
  3. Polito, Vito & Spencer, Peter, 2011. "UK Macroeconomic Volatility and the Welfare Costs of Inflation," Cardiff Economics Working Papers E2011/23, Cardiff University, Cardiff Business School, Economics Section.

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