The Performance of Forward-Looking Monetary Policy Rules under Model Uncertainty
AbstractRecently, increasing attention is being devoted to interest rate rules that respond directly to economic forecasts rather than relying on current and past observations. Empirical studies suggest this 'forward-looking' rule provides a reasonable description of recent monetary policy in several industrial countries. Such rules are also advocated on analytical grounds including simplicity, transparency, and efficiency. But, such rules can fail to generate unique rational expectations equilibrium under various combinations of structural and policy parameters, raising concerns whether forward-looking rules are robust to model uncertainty. Here, we analyze the efficiency and robustness of forward-looking rules using four structural macroeconometric models of the U.S. economy: the Fuhrer-Moore model, Taylor's Multi-Country Model, the MSR model of Orphanides and Wieland, and the FRB staff model. All four incorporate assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in other respects such as real expenditures and the dynamics of prices. We assume a policy objective of minimizing a weighted sum of the unconditional variances of the inflation rate, the output gap, and federal funds rate changes. For given model and particular class of policy rules, we determine the region of the parameter space for which simple forward-looking and backward-looking rules generate unique equilibria. Within this region, we determine the performance of rules on the policy frontier -- the best obtainable outcomes for output, inflation, and funds-rate volatilities. Finally, we evaluate robustness to model uncertainty, taking rules that perform well in one model and assessing their performance in each of the other three. Our analysis yields three significant conclusions. First, the indeterminacy problem is not one of practical concern. All four models exhibit a relatively high degree of nominal and real inertia consistent with U.S. data. Second, in each model, we find that forward-looking rules provide negligible stabilization benefits compared with well-designed backward-looking rules. Finally, the forward-looking rules that perform well in one model often perform very poorly in the other three. By contrast, simple backward-looking rules taken from the policy frontier of one model are generally very close to the frontier in each of the other three. Thus, while small improvements in output and inflation variability can sometimes be obtained using forward-looking rules, we find them to be much less robust to model uncertainty than simple backward-looking rules.
Download InfoTo our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.
Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 1999 with number 1153.
Date of creation: 01 Mar 1999
Date of revision:
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Keith Kuester & Volker Wieland, 2008.
"Insurance policies for monetary policy in the euro area,"
08-29, Federal Reserve Bank of Philadelphia.
- Keith Kuester & Volker Wieland, 2010. "Insurance Policies for Monetary Policy in the Euro Area," Journal of the European Economic Association, MIT Press, MIT Press, vol. 8(4), pages 872-912, 06.
- Keith Kuester & Volker Wieland, 2010. "Insurance Policies for Monetary Policy in the Euro Area," Journal of the European Economic Association, European Economic Association, European Economic Association, vol. 8(4), pages 872-912, 06.
- Volker Wieland & Keith Kuester, 2005. "Insurance Policies for Monetary Policy in the Euro Area," Computing in Economics and Finance 2005, Society for Computational Economics 100, Society for Computational Economics.
- Küster, Keith & Wieland, Volker, 2005. "Insurance Policies for Monetary Policy in the Euro Area," CEPR Discussion Papers 4956, C.E.P.R. Discussion Papers.
- Kuester, Keith & Wieland, Volker, 2005. "Insurance policies for monetary policy in the euro area," Working Paper Series, European Central Bank 0480, European Central Bank.
- Küster, Keith & Wieland, Volker, 2005. "Insurance policies for monetary policy in the Euro area," CFS Working Paper Series 2005/13, Center for Financial Studies (CFS).
- Keith Kuester & Volker Wieland, 2008. "Insurance Policies for Monetary Policy in the Euro Area," Discussion Papers, Stanford Institute for Economic Policy Research 07-044, Stanford Institute for Economic Policy Research.
- David Kendrick & Hans Amman, 2006.
"A Classification System for Economic Stochastic Control Models,"
Computational Economics, Society for Computational Economics,
Society for Computational Economics, vol. 27(4), pages 453-481, June.
- Hans M. Amman & David A. Kendrick, 2003. "A Classification System for Economic Stochastic Control Models," Computing in Economics and Finance 2003 114, Society for Computational Economics.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If references are entirely missing, you can add them using this form.