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Should Monetary Policy Respond Strongly to Output Gaps?

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Bennett T. McCallum

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Abstract

Much recent monetary policy analysis has featured stochastic simulations with small structural macroeconomic models that include: a spending vs. saving ( IS') sector; a price-adjustment sector; and an interest rate policy rule. The first two are frequently specified so as to reflect optimizing behavior; policy may or may not be specified as optimizing depending on the study's objectives. Some leading issues concern modifications to simple quantitative optimizing models that are needed to generate realistic degrees of persistence in inflation and output-gap variables. A major policy issue is whether it is desirable for monetary policy to respond strongly to the output gap. The paper argues that the latter is unobservable and considers the implications of using a trend-type measure while the true concept is of a type more in keeping with basic theory. In such circumstances, highly undesirable consequences are likely to ensue if policy responds strongly to the measured gap.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8226.

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Date of creation: Apr 2001
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Handle: RePEc:nbr:nberwo:8226

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Find related papers by JEL classification:
E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General

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References listed on IDEAS
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  1. Wallace, Neil, 2000. "Comment on Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 931-35, November.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  3. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  4. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12. [Downloadable!]
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  6. Bennett T. McCallum & Edward Nelson, 1998. "Performance of Operational Policy Rules in an Estimated Semi-Classical Structural Model," NBER Working Papers 6599, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Athanasios Orphanides, 2000. "The quest for prosperity without inflation," Working Paper Series 15, European Central Bank. [Downloadable!]
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  8. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June. [Downloadable!] (restricted)
  9. Robert G. King & Alexander L. Wolman, 1996. "Inflation Targeting in a St. Louis Model of the 21st Century," NBER Working Papers 5507, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Fuhrer, Jeff & Moore, George, 1995. "Inflation Persistence," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 127-59, February. [Downloadable!] (restricted)
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  11. Christiano, Lawrence J, 2000. "Comment on Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 905-30, November.
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