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Monetary Policy Rules under Heterogeneous Inflation Expectations

  • Sophocles N. Brissimis

    ()

    (Bank of Greece, Economic Research Department and University of Piraeus)

  • Nicholas S. Magginas

    (National Bank of Greece)

This paper evaluates the role of inflation-forecast heterogeneity in US monetary policy making. The deviation between private and central bank inflation forecasts is identified as a factor increasing inflation persistence and thus calling for a policy reaction. An optimal policy rule is derived by the minimization under discretion of a standard central bank loss function subject to a Phillips curve, modified to include the forecast deviation, and a forward-looking aggregate demand equation. This rule, which itself includes the forecast deviation as an additional argument, is estimated for the period 1974-1998, covering the Chairmanships of Arthur Burns, Paul Volcker and Alan Greenspan, by using real-time forecasts of inflation and the output gap obtained from the FOMC’s Greenbook and the Survey of Professional Forecasters. The estimated rule remains remarkably stable over the whole sample period, challenging the conventional view of a structural break following Volcker’s appointment as Chairman of the Fed. Finally, the substantial decline in the significance of the interest-rate smoothing term in the rule indicates that monetary policy inertia may, to a large extent, be an artifact of serially correlated inflation-forecast errors that feed into policy decisions in real time.

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Paper provided by Bank of Greece in its series Working Papers with number 35.

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Length: 38 pages
Date of creation: Mar 2006
Date of revision:
Handle: RePEc:bog:wpaper:35
Contact details of provider: Web page: http://www.bankofgreece.gr

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  1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "Monetary policy rules and macroeconomic stability: Evidence and some theory," Economics Working Papers 350, Department of Economics and Business, Universitat Pompeu Fabra, revised May 1999.
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  4. Francesco Lippi & Stefano Neri, 2004. "Information variables for monetary policy in a small structural model of the euro area," Temi di discussione (Economic working papers) 511, Bank of Italy, Economic Research and International Relations Area.
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  13. Brissimis, Sophocles N. & Magginas, Nicholas S., 2006. "Forward-looking information in VAR models and the price puzzle," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1225-1234, September.
  14. Athanasios Orphanides, 2002. "Monetary-Policy Rules and the Great Inflation," American Economic Review, American Economic Association, vol. 92(2), pages 115-120, May.
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  20. Orphanides, Athanasios, 2003. "Historical monetary policy analysis and the Taylor rule," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 983-1022, July.
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  23. Orlando Gomes, 2004. "Optimal Monetary Policy under Heterogeneous Expectations," Macroeconomics 0409023, EconWPA.
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