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Modelling and Identifying Central Banks' Preferences

  • Favero, Carlo A.
  • Rovelli, Riccardo

We propose an approach to identify independently the parameters describing the structure of the economy from those describing central bank preferences. We first estimate a parsimonious structural model for US inflation, US output-gap and the world commodity price index. We then proceed to the identification of central bank preferences by estimating by GMM the Euler equations for the solution of the intertemporal optimization problem relevant to the central bank. The empirical analysis of the structural model shows that the persistency of real interest rates effects on aggregate demand is sufficient to generate an autoregressive structure in any interest rate rule. From estimation of the Euler equations, we infer that strict inflation targeting together with real interest rate smoothing delivers an optimal policy rule capable of replicating the observed path of real interest rates over the sample 1983:1 - 1998:3. Our empirical findings imply that the output gap enters into the optimal interest rate rule only as a leading indicator of future inflation, and we reject the hypothesis that output stabilization is an independent argument in the loss of function of the Fed.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2178.

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Date of creation: Jun 1999
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Handle: RePEc:cpr:ceprdp:2178
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  1. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
  2. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
  3. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring monetary policy," Working Papers in Applied Economic Theory 95-09, Federal Reserve Bank of San Francisco.
  4. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  5. Svensson, Lars, 1999. "Does the P* Model provide Any Rationale for Monetary Targeting?," Seminar Papers 671, Stockholm University, Institute for International Economic Studies.
  6. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  7. Cecchetti, Stephen G & McConnell, Margaret M & Perez-Quiros, Gabriel, 2002. "Policymakers' Revealed Preferences and the Output-Inflation Variability Trade-Off: Implications for the European System of Central Banks," Manchester School, University of Manchester, vol. 70(4), pages 596-618, Special I.
  8. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
  9. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
  10. Richard H. Clarida & Mark Gertler, 1997. "How the Bundesbank Conducts Monetary Policy," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 363-412 National Bureau of Economic Research, Inc.
  11. Glenn D. Rudebusch, 2001. "Is The Fed Too Timid? Monetary Policy In An Uncertain World," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 203-217, May.
  12. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  13. Brian Sack, 1998. "Does the Fed act gradually? a VAR analysis," Finance and Economics Discussion Series 1998-17, Board of Governors of the Federal Reserve System (U.S.).
  14. Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond.
  15. Goodfriend, Marvin, 1987. "Interest rate smoothing and price level trend-stationarity," Journal of Monetary Economics, Elsevier, vol. 19(3), pages 335-348, May.
  16. John B. Taylor, 1996. "How should monetary policy respond to shocks while maintaining long-run price stability? Conceptual issues," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 181-195.
  17. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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