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Time varying equilibrium real rates and monetary policy analysis

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  • Bharat Trehan
  • Tao Wu

Abstract

Although it is generally recognized that the equilibrium real interest rate (ERR) varies over time, most recent work on policy analysis has been carried out under the assumption that this rate is constant. We show how this assumption can affect inferences about the conduct of policy in two different areas. First, if the ERR moves in the same direction as the trend growth rate (as is suggested by theory), the probability that an unperceived change in trend growth will lead to a substantial change in inflation is noticeably lower than is suggested by recent analyses (of inflation in the 1970s, for example) that assume a constant ERR. Second, if the monetary authority targets a time varying ERR but the econometrician assumes otherwise, estimated policy rules will tend to exaggerate the degree of interest rate smoothing as well as the weight that the monetary authority places upon inflation.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2004-10.

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Date of creation: 2004
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Handle: RePEc:fip:fedfwp:2004-10

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Keywords: Interest rates ; Monetary policy ; Taylor's rule;

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References

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  1. Thomas Laubach and John C. Williams, 2001. "Measuring the Natural Rate of Interest," Computing in Economics and Finance 2001 35, Society for Computational Economics.
  2. Goodfriend, Marvin, 1991. "Interest rates and the conduct of monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 34(1), pages 7-30, January.
  3. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
  4. Clark, Todd E. & Kozicki, Sharon, 2004. "Estimating equilibrium real interest rates in real-time," Discussion Paper Series 1: Economic Studies 2004,32, Deutsche Bundesbank, Research Centre.
  5. Kozicki, Sharon & Tinsley, P. A., 2001. "Term structure views of monetary policy under alternative models of agent expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 25(1-2), pages 149-184, January.
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  8. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
  9. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  10. English William B. & Nelson William R. & Sack Brian P., 2003. "Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-18, April.
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  13. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, May.
  14. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters, in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
  15. James Bullard & Stefano Eusepi, 2003. "Did the Great Inflation occur despite policymaker commitment to a Taylor rule?," Working Paper 2003-20, Federal Reserve Bank of Atlanta.
  16. Kevin J. Lansing, 2002. "Real-time estimation of trend output and the illusion of interest rate smoothing," Economic Review, Federal Reserve Bank of San Francisco, pages 17-34.
  17. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  18. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
  19. John B. Taylor, 1999. "Introduction to "Monetary Policy Rules"," NBER Chapters, in: Monetary Policy Rules, pages 1-14 National Bureau of Economic Research, Inc.
  20. Barro, Robert J., 1989. "Interest-rate targeting," Journal of Monetary Economics, Elsevier, vol. 23(1), pages 3-30, January.
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