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Monetary Policy with Imperfect Knowledge

  • Athanasios Orphanides
  • John C. Williams

We examine the performance and robustness of monetary policy rules when the central bank and the public have imperfect knowledge of the economy and continuously update their estimates of model parameters. We find that versions of the Taylor rule calibrated to perform well under rational expectations with perfect knowledge perform very poorly when agents are learning and the central bank faces uncertainty regarding natural rates. In contrast, difference rules, in which the change in the interest rate is determined by the inflation rate and the change in the unemployment rate, perform well when knowledge is both perfect and imperfect. (JEL: E52) (c) 2006 by the European Economic Association.

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Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 4 (2006)
Issue (Month): 2-3 (04-05)
Pages: 366-375

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Handle: RePEc:tpr:jeurec:v:4:y:2006:i:2-3:p:366-375
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  1. Athanasios Orphanides & John C. Williams, 2003. "The decline of activist stabilization policy: natural rate misperceptions, learning, and expectations," Working Paper Series 2003-24, Federal Reserve Bank of San Francisco.
  2. John C. Williams, 2004. "Robust estimation and monetary policy with unobserved structural change," Working Paper Series 2004-11, Federal Reserve Bank of San Francisco.
  3. Athanasios Orphanides & John C. Williams, 2006. "Inflation Targeting Under Imperfect Knowledge," Working Papers Central Bank of Chile 398, Central Bank of Chile.
  4. Athanasios Orphanides & John C. Williams, 2003. "Inflation scares and forecast-based monetary policy," Working Paper Series 2003-11, Federal Reserve Bank of San Francisco.
  5. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Finance and Economics Discussion Series 2002-27, Board of Governors of the Federal Reserve System (U.S.).
  6. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
  7. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series 2003-11, Board of Governors of the Federal Reserve System (U.S.).
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