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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 S. 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6518.

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Date of creation: Sep 2000
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Publication status: published as Monetary Policy Rules, edited by John B. Taylor, pp. 405-430, 1999. The University of Chicago Press.
Handle: RePEc:nbr:nberwo:6518

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  1. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CFS Working Paper Series 2003/05, Center for Financial Studies (CFS).
  2. Svensson, Lars E.O., 1997. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Seminar Papers, Stockholm University, Institute for International Economic Studies 615, Stockholm University, Institute for International Economic Studies.
  3. Marco A. Espinosa-Vega & Steven Russell, 1997. "History and theory of the NAIRU: a critical review," Economic Review, Federal Reserve Bank of Atlanta, Federal Reserve Bank of Atlanta, issue Q 2, pages 4-25.
  4. 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, American Economic Association, vol. 85(1), pages 219-39, March.
  5. Arturo Estrella, 1997. "Aggregate supply and demand shocks: a natural rate approach," Research Paper, Federal Reserve Bank of New York 9739, Federal Reserve Bank of New York.
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  14. Edmund S. Phelps, 1968. "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 76, pages 678.
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