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Simple rules for monetary policy

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  • John C. Williams

Abstract

What is a good monetary policy rule for stabilizing the economy? In this paper, efficient policy rules are computed using the FRB/US large-scale open-economy macroeconometric model. Simple three-parameter policy rules are found to be very effective at minimizing fluctuations in inflation, output, and interest rates: Increases in rule complexity yield only trivial reductions in aggregate variability. Under rational expectations, efficient policies smooth the interest rate response to shocks and use the feedback from anticipated policy actions to stabilize inflation and output and to moderate movements in short-term interest rates. Policy should react to a multi-period inflation rate rather than the current quarter inflation rate; in fact, targeting the price level, as opposed to the inflation rate, involves only small additional stabilization costs. These results are robust to parameter and model uncertainty and the imposition of the non-negativity constraint on nominal interest rates. However, if expectations formation is invariant to policy, as in backward-looking models, the expectations channel is shut off and the performance of policies that are efficient under rational expectations may, as a result, deteriorate markedly; efficient policies, in contrast, exploit systematic expectational errors.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-12.

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Date of creation: 1999
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Handle: RePEc:fip:fedgfe:1999-12

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Keywords: Monetary policy;

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References

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  1. Glenn D. Rudebusch, 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Working Papers in Applied Economic Theory 95-02, Federal Reserve Bank of San Francisco.
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  3. Taylor, John B, 1979. "Estimation and Control of a Macroeconomic Model with Rational Expectations," Econometrica, Econometric Society, vol. 47(5), pages 1267-86, September.
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  9. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  10. Ray C. Fair & E. Philip Howrey, 1995. "Evaluating Alternative Monetary Policy Rules," Cowles Foundation Discussion Papers 1091, Cowles Foundation for Research in Economics, Yale University.
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  13. Ball, Laurence, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
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  15. Flint Brayton & Eileen Mauskopf & David Reifschneider & Peter Tinsley & John Williams, 1997. "The role of expectations in the FRB/US macroeconomic model," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Apr, pages 227-245.
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  20. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," International Tax and Public Finance, Springer, vol. 6(4), pages 537-577, November.
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  23. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  24. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
  25. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
  26. Henderson, Dale W. & McKibbin, Warwick J., 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 221-317, December.
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