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Monetary Policy with Judgement: Forecast Targeting

  • Svensson, Lars E O

‘Forecast targeting’, forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the US economy, one forward looking and one backward looking. A complicated infinite-horizon central bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank’s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5072.

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Date of creation: May 2005
Handle: RePEc:cpr:ceprdp:5072
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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. Albert Marcet & Ramon Marimon, 1994. "Recursive contracts," Economics Working Papers 337, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 1998.
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  4. Bennett T. McCallum & Edward Nelson, 2005. "Targeting versus instrument rules for monetary policy," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 225-245.
  5. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  6. Lars E.O. Svensson & Kjetil Houg & Haakon O.Aa. Solheim & Erling Steigum, 2002. "An Independent Review of Monetary Policy and Institutions in Norway," Working Papers 120, Princeton University, Department of Economics, Center for Economic Policy Studies..
  7. repec:pri:cepsud:82svensson is not listed on IDEAS
  8. Noah Williams & Lars E.O. Svensson, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," Computing in Economics and Finance 2005 108, Society for Computational Economics.
  9. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-1311, July.
  10. Jon Faust & Dale W. Henderson, 2004. "Is inflation targeting best-practice monetary policy?," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 117-144.
  11. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
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  13. Christopher A. Sims, 2002. "The Role of Models and Probabilities in the Monetary Policy Process," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 33(2), pages 1-62.
  14. Lars E. O. Svensson & Robert J. Tetlow, 2005. "Optimal policy projections," Finance and Economics Discussion Series 2005-34, Board of Governors of the Federal Reserve System (U.S.).
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  17. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September.
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  19. Sharon Kozicki, 1999. "How useful are Taylor rules for monetary policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-33.
  20. Lars E.O. Svensson, 2004. "Targeting Rules vs. Instrument Rules for Monetary Policy: What is Wrong with McCallum and Nelson?," NBER Working Papers 10747, National Bureau of Economic Research, Inc.
  21. Reifschneider, David L. & Stockton, David J. & Wilcox, David W., 1997. "Econometric models and the monetary policy process," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 1-37, December.
  22. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  23. Walsh, Carl E, 2004. "Robustly Optimal Instrument Rules and Robust Control: An Equivalence Result," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(6), pages 1105-13, December.
  24. Backus, David & Driffill, John, 1986. "The Consistency of Optimal Policy in Stochastic Rational Expectations Models," CEPR Discussion Papers 124, C.E.P.R. Discussion Papers.
  25. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  26. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  27. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
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