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A defense of moderation in monetary policy

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  • Williams, John C.

Abstract

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.

Suggested Citation

  • Williams, John C., 2013. "A defense of moderation in monetary policy," Journal of Macroeconomics, Elsevier, vol. 38(PB), pages 137-150.
  • Handle: RePEc:eee:jmacro:v:38:y:2013:i:pb:p:137-150
    DOI: 10.1016/j.jmacro.2013.07.010
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    References listed on IDEAS

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    1. Athanasios Orphanides & John C. Williams, 2006. "Monetary Policy with Imperfect Knowledge," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 366-375, 04-05.
    2. Wieland, Volker, 2000. "Monetary policy, parameter uncertainty and optimal learning," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 199-228, August.
    3. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
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    9. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
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    13. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
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    15. Soderstrom, Ulf, 2002. " Monetary Policy with Uncertain Parameters," Scandinavian Journal of Economics, Wiley Blackwell, vol. 104(1), pages 125-145.
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    17. Han Chen & Vasco Cúrdia & Andrea Ferrero, 2012. "The Macroeconomic Effects of Large‐scale Asset Purchase Programmes," Economic Journal, Royal Economic Society, vol. 122(564), pages 289-315, November.
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    Cited by:

    1. Barnes, Michelle L., 2014. "Let's talk about it: what policy tools should the Fed "normally" use?," Current Policy Perspectives 14-12, Federal Reserve Bank of Boston.
    2. Chuliá, Helena & Guillén, Montserrat & Uribe, Jorge M., 2017. "Measuring uncertainty in the stock market," International Review of Economics & Finance, Elsevier, vol. 48(C), pages 18-33.
    3. Francois Gourio & Jonas Fisher, 2015. "Risk Management for Monetary Policy at the Zero Lower Bound," 2015 Meeting Papers 665, Society for Economic Dynamics.
    4. Clavero, Borja, 2017. "A contribution to the Quantity Theory of Disaggregated Credit," MPRA Paper 76657, University Library of Munich, Germany.
    5. repec:bin:bpeajo:v:47:y:2016:i:2016-02:p:1-55 is not listed on IDEAS
    6. Narayana Kocherlakota, 2016. "Rules versus Discretion: A Reconsideration," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 47(2 (Fall)), pages 1-55.

    More about this item

    Keywords

    Optimal monetary policy; Uncertainty; Bayesian decision making; Unconventional monetary policy;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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