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Modeling the Components of Market Discipline

  • Faidon Kalfaoglou


    (Bank of Greece)

  • Alexandros Sarris

    (Food and Agricultural Organization of the United Nations and University of Athens)

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    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 36.

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    Length: 38 pages
    Date of creation: Apr 2006
    Date of revision:
    Handle: RePEc:bog:wpaper:36
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