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A defense of moderation in monetary policy

  • Williams, John C.

This paper examines the implications of uncertainty about the effects of monetary policy for optimal monetary policy with an application to the current situation. Using a stylized macroeconomic model, I derive optimal policies under uncertainty for both conventional and unconventional monetary policies. According to an estimated version of this model, the US economy is currently suffering from a large and persistent adverse demand shock. Optimal monetary policy absent uncertainty would quickly restore real GDP close to its potential level and allow the inflation rate to rise temporarily above the longer-run target. By contrast, the optimal policy under uncertainty is more muted in its response. As a result, output and inflation return to target levels only gradually. This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Second, one cannot simply look at point forecasts and judge whether policy is optimal. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument associated with the least uncertainty and use alternative, more uncertain instruments only when the least uncertain instrument is employed to its fullest extent possible.

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Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 38 (2013)
Issue (Month): PB ()
Pages: 137-150

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Handle: RePEc:eee:jmacro:v:38:y:2013:i:pb:p:137-150
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  1. Thomas Laubach and John C. Williams, 2001. "Measuring the Natural Rate of Interest," Computing in Economics and Finance 2001 35, Society for Computational Economics.
  2. John C. Williams, 1999. "Simple rules for monetary policy," Finance and Economics Discussion Series 1999-12, Board of Governors of the Federal Reserve System (U.S.).
  3. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  4. Wieland, Volker, 2000. "Monetary policy, parameter uncertainty and optimal learning," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 199-228, August.
  5. 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, vol. 25(6-7), pages 911-949, June.
  6. Athanasios Orphanides & John C. Williams, 2005. "Monetary policy with imperfect knowledge," Working Paper Series 2005-17, Federal Reserve Bank of San Francisco.
  7. Rudebusch, G.D. & Svensson, L.E.O., 1998. "Policy Rules for Inflation Targeting," Papers 637, Stockholm - International Economic Studies.
  8. Han Chen & Vasco Cúrdia & Andrea Ferrero, 2011. "The macroeconomic effects of large-scale asset purchase programs," Staff Reports 527, Federal Reserve Bank of New York.
  9. Thomas Laubach & John C. Williams & Rochelle M. Edge, 2007. "Welfare-Maximizing Monetary Policy under Parameter Uncertainty," 2007 Meeting Papers 311, Society for Economic Dynamics.
  10. Canlin Li & Min Wei, 2013. "Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Progarms," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 3-39, March.
  11. David L. Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
  12. Söderström, Ulf, 2000. "Monetary policy with uncertain parameters," Working Paper Series 0013, European Central Bank.
  13. Michael T. Kiley, 2014. "The Aggregate Demand Effects of Short- and Long-Term Interest Rates," International Journal of Central Banking, International Journal of Central Banking, vol. 10(4), pages 69-104, December.
  14. John C. Williams, 2011. "Unconventional monetary policy: lessons from the past three years," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct3.
  15. John C. Williams, 2012. "The Federal Reserve’s unconventional policies," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov13.
  16. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
  17. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  18. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  19. Glenn D. Rudebusch & John C. Williams, 2008. "Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections," NBER Chapters, in: Asset Prices and Monetary Policy, pages 247-289 National Bureau of Economic Research, Inc.
  20. John C. Williams & Andrew T. Levin, 2003. "Parameter Uncertainty and the Central Bank's Objective Function," Computing in Economics and Finance 2003 215, Society for Computational Economics.
  21. Glenn D. Rudebusch, 2001. "Is The Fed Too Timid? Monetary Policy In An Uncertain World," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 203-217, May.
  22. Baumeister, Christiane & Benati, Luca, 2010. "Unconventional monetary policy and the great recession - Estimating the impact of a compression in the yield spread at the zero lower bound," Working Paper Series 1258, European Central Bank.
  23. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
  24. Woodford, Michael, 2013. "Forward Guidance by Inflation-Targeting Central Banks," CEPR Discussion Papers 9722, C.E.P.R. Discussion Papers.
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