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Rethinking the role of NAIRU in monetary policy: implications of model formulation and uncertainty

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  • Arturo Estrella
  • Frederic Mishkin

Abstract

In this paper we rethink the NAIRU concept and examine whether it might have a useful role in monetary policy. We argue that it can, but success depends critically on defining NAIRU as a short-run concept and distinguishing it from a long-run concept like the natural rate of unemployment. We examine what effect uncertainty has on the use of NAIRU in policy. Uncertainty about the level of NAIRU does not imply that monetary policy should react less to the NAIRU gap. However, uncertainty about the effect of the NAIRU gap on inflation does require adjustments to the policy reaction function. Also, as in Brainard (1967), uncertainty about the effect of the monetary policy instrument on the NAIRU gap reduces the magnitude of the policy response. We estimate a simple NAIRU gap model for the United States to obtain quantitative measures of uncertainty and to assess how these measures affect our view of the policy reaction function.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9806.

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Date of creation: 1998
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Handle: RePEc:fip:fednrp:9806

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Keywords: Unemployment ; Monetary policy;

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  1. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
  2. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  3. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
  4. Volker Wieland, . "Monetary Policy and Uncertainty about the Natural Unemployment Rate," Computing in Economics and Finance 1997 11, Society for Computational Economics.
  5. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  6. Layard, R. & Bean, C., 1988. "Why Does Unemployment Persist?," Papers 321, London School of Economics - Centre for Labour Economics.
  7. Robert J. Gordon, 1996. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  8. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  9. Franco Modigliani & Lucas Papademos, 1975. "Targets for Monetary Policy in the Coming Year," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 141-166.
  10. Arturo Estrella, 1997. "Aggregate supply and demand shocks: a natural rate approach," Research Paper 9739, Federal Reserve Bank of New York.
  11. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, octubre-d.
  12. Marco A. Espinosa-Vega & Steven Russell, 1997. "History and theory of the NAIRU: a critical review," Economic Review, Federal Reserve Bank of Atlanta, issue Q 2, pages 4-25.
  13. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  14. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  15. Edmund S. Phelps, 1968. "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 76, pages 678.
  16. Joseph Stiglitz, 1997. "Reflections on the Natural Rate Hypothesis," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 3-10, Winter.
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