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Learning about a shift in trend output: implications for monetary policy and inflation

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  • Kevin J. Lansing

Abstract

This paper develops a small forward-looking macroeconomic model where the Federal Reserve estimates the level of potential output in real time by running a regression on past output data. The Fed's perceived output gap is used as an input to the monetary policy rule while the true output gap influences aggregate demand and inflation. I investigate the consequences of two postulated shifts in the growth rate of U.S. potential output: the first occurs in the early-1970s and the second in the mid-1990s. Initially, Fed policymakers interpret these shifts to be cyclical shocks but their regression algorithm allows them to gradually discover the truth as the economy evolves over time. Under a Taylor-type rule, the model can produce a hump-shaped pattern in trend inflation that peaks around 1979 and a downward movement in trend inflation since 1995. Under a nominal income growth rule, these low-frequency movements in inflation are substantially reduced but not eliminated. The business cycle stabilization properties of the two rules turn out to be quite similar. Finally, using stochastic simulations, I show that efforts to identify the Fed's policy rule using a regression based on final data can create the illusion of strong interest rate smoothing behavior when in fact none exists.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2000-16.

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Date of creation: 2002
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Handle: RePEc:fip:fedfwp:2000-16

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Keywords: Macroeconomics ; Econometric models ; Monetary policy ; Inflation (Finance) ; Business cycles;

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Cited by:
  1. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator Variables for Optimal Policy," NBER Working Papers 7953, National Bureau of Economic Research, Inc.
  2. Edward Nelson & Kalin Nikolov, 2001. "UK inflation in the 1970s and 1980s: the role of output gap mismeasurement," Bank of England working papers 148, Bank of England.
  3. Yash P. Mehra, 2002. "The Taylor principle, interest rate smoothing and Fed policy in the 1970s and 1980s," Working Paper 02-03, Federal Reserve Bank of Richmond.
  4. Andersen, Torben M. & Beier, Niels C., 2005. "International transmission of transitory and persistent monetary shocks under imperfect information," Journal of International Economics, Elsevier, vol. 66(2), pages 485-507, July.
  5. Ehrmann, Michael & Smets, Frank, 2003. "Uncertain potential output: implications for monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 27(9), pages 1611-1638, July.
  6. Cukierman, Alex & Lippi, Francesco, 2003. "Endogenous Monetary Policy with Unobserved Potential Output," CEPR Discussion Papers 3763, C.E.P.R. Discussion Papers.
  7. Edge, Rochelle M. & Laubach, Thomas & Williams, John C., 2007. "Learning and shifts in long-run productivity growth," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2421-2438, November.
  8. Viñals, José, 2001. "Monetary Policy Issues in a Low Inflation Environment," CEPR Discussion Papers 2945, C.E.P.R. Discussion Papers.
  9. Robert R Tchaidze, 2001. "Estimating Taylor Rules in a Real Time Setting," Economics Working Paper Archive 457, The Johns Hopkins University,Department of Economics.
  10. Rochelle Edge & Thomas Laubach, 2004. "Learning and Shifts in Long-Run Growth," Computing in Economics and Finance 2004 123, Society for Computational Economics.
  11. Camba-Mendez, Gonzalo & Rodriguez-Palenzuela, Diego, 2003. "Assessment criteria for output gap estimates," Economic Modelling, Elsevier, vol. 20(3), pages 529-562, May.

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