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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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File URL: http://www.sciencedirect.com/science/article/pii/S0164070413001201
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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
DOI: 10.1016/j.jmacro.2013.07.010
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622617

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  1. 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.
  2. 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.
  3. Michael T. Kiley, 2012. "The aggregate demand effects of short- and long-term interest rates," Finance and Economics Discussion Series 2012-54, Board of Governors of the Federal Reserve System (U.S.).
  4. 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.
  5. Vasco Curdia & Andrea Ferrero & Han Chen, 2012. "The Macroeconomic Effects of Large-Scale Asset Purchase Programs," 2012 Meeting Papers 372, Society for Economic Dynamics.
  6. Athanasios Orphanides & John C. Williams, 2005. "Monetary policy with imperfect knowledge," Finance and Economics Discussion Series 2005-51, Board of Governors of the Federal Reserve System (U.S.).
  7. Thomas Laubach & John C. Williams, 2001. "Measuring the natural rate of interest," Finance and Economics Discussion Series 2001-56, Board of Governors of the Federal Reserve System (U.S.).
  8. Rudebusch, G.D. & Svensson, L.E.O., 1998. "Policy Rules for Inflation Targeting," Papers 637, Stockholm - International Economic Studies.
  9. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
  10. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2007. "Welfare-maximizing monetary policy under parameter uncertainty," Proceedings, Federal Reserve Bank of San Francisco.
  11. John C. Williams, 2012. "The Federal Reserve’s unconventional policies," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov13.
  12. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  13. Wieland, Volker, 1999. "Monetary policy, parameter uncertainty and optimal learning," ZEI Working Papers B 09-1999, University of Bonn, ZEI - Center for European Integration Studies.
  14. John C. Williams, 2003. "Simple rules for monetary policy," Economic Review, Federal Reserve Bank of San Francisco, pages 1-12.
  15. 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.
  16. John C. Williams, 2011. "Unconventional monetary policy: lessons from the past three years," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct3.
  17. Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
  18. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  19. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  20. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
  21. Söderström, Ulf, 1999. "Monetary policy with uncertain parameters," SSE/EFI Working Paper Series in Economics and Finance 308, Stockholm School of Economics.
  22. 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.
  23. 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.
  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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