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Optimal Policy Projections

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  • Svensson, Lars O
  • Tetlow, Robert J

Abstract

We outline a method to provide advice on optimal monetary policy while taking policymakers’ judgment into account. The method constructs optimal policy projections (OPPs) by extracting the judgment terms that allow a model, such as the Federal Reserve Board staff economic model, FRB/US, to reproduce a forecast, such as the Greenbook forecast. Given an intertemporal loss function that represents monetary policy objectives, OPPs are the projections — of target variables, instruments, and other variables of interest — that minimize that loss function for given judgment terms. The method is illustrated by revisiting the economy of early 1997 as seen in the Greenbook forecasts of February 1997 and November 1999. In both cases, we use the vintage of the FRB/US model that was in place at that time. These two particular forecasts were chosen, in part, because they were at the beginning and the peak, respectively, of the late 1990s boom period. As such, they differ markedly in their implied judgments of the state of the world in 1997 and our OPPs illustrate this difference. For a conventional loss function, our OPPs provide significantly better performance than Taylor-rule simulations.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 839.

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Date of creation: 08 Aug 2005
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Publication status: Published in International Journal of Central Banking Number 3.Volume(2005): pp. 177-207
Handle: RePEc:pra:mprapa:839

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  1. Ray C. Fair & John B. Taylor, 1980. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear RationalExpectations Models," NBER Technical Working Papers 0005, National Bureau of Economic Research, Inc.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
  3. Alan Greenspan, 2004. "Risk and Uncertainty in Monetary Policy," American Economic Review, American Economic Association, American Economic Association, vol. 94(2), pages 33-40, May.
  4. David Reifschneider & Robert Tetlow & John Williams, 1999. "Aggregate disturbances, monetary policy, and the macroeconomy: the FRB/US perspective," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-19.
  5. Svensson, Lars O, 2005. "Monetary Policy with Judgment: Forecast Targeting," MPRA Paper 819, University Library of Munich, Germany.
  6. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 25(6-7), pages 911-949, June.
  7. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2003-11, Board of Governors of the Federal Reserve System (U.S.).
  8. Hansen, Lars Peter & Sargent, Thomas J., 2003. "Robust control of forward-looking models," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(3), pages 581-604, April.
  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  10. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  11. Kalchbrenner, J H & Tinsley, Peter A, 1976. "On the Use of Feedback Control in the Design of Aggregate Monetary Policy," American Economic Review, American Economic Association, American Economic Association, vol. 66(2), pages 349-55, May.
  12. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
  13. F. Brayton & P. Tinsley, 1996. "A guide to FRB/US: a macroeconomic model of the United States," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 96-42, Board of Governors of the Federal Reserve System (U.S.).
  14. John C. Williams & Andrew T. Levin, 2003. "Robust Monetary Policy with Competing Reference Models," Computing in Economics and Finance 2003 291, Society for Computational Economics.
  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.), Board of Governors of the Federal Reserve System (U.S.), issue Apr, pages 227-245.
  16. Brayton, Flint & Levin, Andrew & Lyon, Ralph & Williams, John C., 1997. "The evolution of macro models at the Federal Reserve Board," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 47(1), pages 43-81, December.
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