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Endogenous monetary policy with unobserved potential output

  • Alex Cukierman

    (Tel-Aviv University and Center, Tilburg University)

  • Francesco Lippi

    ()

    (Banca d'Italia)

This paper characterizes endogenous monetary policy when policymakers are uncertain about the extent to which movements in output and inflation are due to changes in potential output or to cyclical demand and cost shocks. We refer to this informational limitation as the "information problem" (IP). Main results of the paper are: 1. Policy is likely to be excessively loose (restrictive) for some time when there is a large decrease (increase) in potential output in comparison with a full information benchmark. 2. Errors in forecasting potential output and the output gap are generally serially correlated. These ndings provide a partial explanation for the inflation of the seventies and the price stability of the nineties. 3. A quantitative assessment, based on an empirical model of the US economy developed by Rudebusch and Svensson (1999), indicates that during and following periods of large changes in potential output the IP significantly affects the dynamics of inflation and output. 4. The increase in the Fed's conservativeness between the seventies and the nineties, and a more realistic appreciation of the uncertainties surrounding potential output in the second period, imply that the IP problem had a stronger impact in the seventies than in the nineties.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 493.

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Date of creation: Jun 2004
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Handle: RePEc:bdi:wptemi:td_493_04
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  1. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy Rules for Inflation Targeting," NBER Working Papers 6512, National Bureau of Economic Research, Inc.
  2. Svensson, Lars E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Seminar Papers 646, Stockholm University, Institute for International Economic Studies.
  3. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
  4. Orphanides, Athanasios, 2003. "The quest for prosperity without inflation," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 633-663, April.
  5. Brunner, Karl & Cukierman, Alex & Meltzer, Allan H., 1980. "Stagflation, persistent unemployment and the permanence of economic shocks," Journal of Monetary Economics, Elsevier, vol. 6(4), pages 467-492, October.
  6. Cukierman, Alex & Miller, Geoffrey & Neyapti, Bilin, 2001. "Central Bank Reform, Liberalization and Inflation in Transition Economies - An International Perspective," CEPR Discussion Papers 2808, C.E.P.R. Discussion Papers.
  7. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  8. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator variables for optimal policy," Proceedings, Federal Reserve Bank of San Francisco.
  9. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  10. Taylor, J.B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by European Central Bank," Papers 649, Stockholm - International Economic Studies.
  11. Lars Peter Hansen & Thomas J. Sargent, 1990. "Recursive Linear Models of Dynamic Economies," NBER Working Papers 3479, National Bureau of Economic Research, Inc.
  12. Douglas O. Staiger & James H. Stock & Mark W. Watson, 1997. "How Precise Are Estimates of the Natural Rate of Unemployment?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 195-246 National Bureau of Economic Research, Inc.
  13. Eric Swanson, 2000. "On Signal Extraction and Non-Certainty-Equivalence in Optimal Monetary Policy Rules," Econometric Society World Congress 2000 Contributed Papers 1085, Econometric Society.
  14. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers.
  15. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  16. Siklos,Pierre L., 2002. "The Changing Face of Central Banking," Cambridge Books, Cambridge University Press, number 9780521780254.
  17. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  18. Ehrmann, M. & Smets, F., 2001. "Uncertain Potential Output: Implications for Monetary Policy," Papers 59, Quebec a Montreal - Recherche en gestion.
  19. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbance," Working papers 497, Massachusetts Institute of Technology (MIT), Department of Economics.
  20. Glenn D. Rudebusch, 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 2000-03, Federal Reserve Bank of San Francisco.
  21. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  22. Kenneth Kuttner, 1992. "Monetary policy with uncertain estimates of potential output," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jan, pages 2-15.
  23. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1.
  24. Gerali, Andrea & Lippi, Francesco, 2003. "Optimal Control and Filtering in Linear Forward-looking Economies: A Toolkit," CEPR Discussion Papers 3706, C.E.P.R. Discussion Papers.
  25. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.).
  26. Kevin J. Lansing, 2000. "Learning about a shift in trend output: implications for monetary policy and inflation," Proceedings, Federal Reserve Bank of San Francisco.
  27. Swanson, Eric T., 2004. "Signal Extraction And Non-Certainty-Equivalence In Optimal Monetary Policy Rules," Macroeconomic Dynamics, Cambridge University Press, vol. 8(01), pages 27-50, February.
  28. Kuttner, Kenneth N, 1994. "Estimating Potential Output as a Latent Variable," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 361-68, July.
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