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How Optimal is US Monetary Policy?

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  • Xiaoshan Chen
  • Tatiana Kirsanova
  • Campbell Leith

Abstract

Most of the literature estimating DSGE models for monetary policy analysis assume that policy follows a simple rule. In this paper we allow policy to be described by various forms of optimal policy - commitment, discretion and quasi-commitment. We find that, even after allowing for Markov switching in shock variances, the inflation target and/or rule parameters, the data preferred description of policy is that the US Fed operates under discretion with a marked increase in conservatism after the 1970s. Parameter estimates are similar to those obtained under simple rules, except that the degree of habits is significantly lower and the prevalence of cost-push shocks greater. Moreover, we find that the greatest welfare gains from the ‘Great Moderation’ arose from the reduction in the variances in shocks hitting the economy, rather than increased inflation aversion. However, much of the high inflation of the 1970s could have been avoided had policy makers been able to commit, even without adopting stronger anti-inflation objectives. More recently the Fed appears to have temporarily relaxed policy following the 1987 stock market crash, and has lost, without regaining, its post-Volcker conservatism following the bursting of the dot-com bubble in 2000.

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2013_08.

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Date of creation: Mar 2013
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Handle: RePEc:gla:glaewp:2013_08

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Keywords: Bayesian Estimation; Interest Rate Rules; Optimal Monetary Policy; Great Mod- eration; Commitment; Discretion;

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References

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  1. Microfounded Social Welfare Functions
    by Mainly Macro in Mainly Macro on 2013-05-04 10:12:00
  2. 'Microfounded Social Welfare Functions'
    by Mark Thoma in Economist's View on 2013-05-04 09:44:30
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Cited by:
  1. Hughes Hallett, Andrew & Rannenberg, Ansgar & Schreiber, Sven, 2014. "New Keynesian versus old Keynesian government spending multipliers: A comment," Discussion Papers 2014/6, Free University Berlin, School of Business & Economics.

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