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Estimating the Revealed Inflation Target: An Application to U.S. Monetary Policy

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Author Info
Daniel Leigh () (European International Monetary Fund)
Abstract

This paper proposes a new method of estimating the Taylor rule with a time-varying implicit inflation target and a time-varying natural rate of interest. The inflation target and the natural rate are modelled as random walks and are estimated using maximum likelihood and the Kalman filter. I apply this method to U.S. monetary policy over the last 25 years to understand how the Federal Reserve’s target has varied during this broadly successful period. Stability tests indicate significant time variation in the implicit target. In the early 1980s, during the Volcker disinflation, the inflation target is near 3%. In the late 1980s and early 1990s, the target is close to actual inflation of 3-4% and only declines once the 1990-91 recession reduces inflation to 1-2%, corroborating historical evidence of an “opportunistic approach to disinflation.†Finally, over 2001-2004, the target rises to 2-3%, behaviour that can be interpreted as a response the risks of hitting the zero bound on nominal interest rates

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 177.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:177

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Related research
Keywords: Taylor rule; time-varying parameters; Kalman filter;

Find related papers by JEL classification:
C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Kenneth N. Kuttner, 2004. "The role of policy rules in inflation targeting," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 89-112. [Downloadable!]
  3. Jane Haltmaier, 2001. "The use of cyclical indicators in estimating the output gap in Japan," International Finance Discussion Papers 701, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  4. Thomas Laubach, 2001. "Measuring The NAIRU: Evidence From Seven Economies," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 218-231, May. [Downloadable!] (restricted)
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  5. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2003-1), pages 139-235. [Downloadable!]
  7. 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. [Downloadable!] (restricted)
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  8. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September. [Downloadable!] (restricted)
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  9. Daniel Leigh, 2004. "Monetary Policy and the Dangers of Deflation:Lessons from Japan," Economics Working Paper Archive 511, The Johns Hopkins University,Department of Economics. [Downloadable!]
  10. Thomas Laubach & John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics, MIT Press, vol. 85(4), pages 1063-1070, November. [Downloadable!] (restricted)
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  11. Ben S. Bernanke & Vincent R. Reinhart, 2004. "Conducting Monetary Policy at Very Low Short-Term Interest Rates," American Economic Review, American Economic Association, vol. 94(2), pages 85-90, May. [Downloadable!]
  12. Orphanides, Athanasios & Wilcox, David W, 2002. "The Opportunistic Approach to Disinflation," International Finance, Blackwell Publishing, vol. 5(1), pages 47-71, Spring. [Downloadable!] (restricted)
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  13. Thomas A. Lubik & Frank Schorfheide, 2004. "Testing for Indeterminacy: An Application to U.S. Monetary Policy," American Economic Review, American Economic Association, vol. 94(1), pages 190-217, March. [Downloadable!]
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