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Optimal nonlinear policy: signal extraction with a non-normal prior

  • Eric T. Swanson

The literature on optimal monetary policy typically makes three major assumptions: (1) policymakers' preferences are quadratic, (2) the economy is linear, and (3) stochastic shocks and policymakers' prior beliefs about unobserved variables are normally distributed. This paper relaxes the third assumption and explores its implications for optimal policy. The separation principle continues to hold in this framework, allowing for tractability and application to forward-looking models, but policymakers' beliefs are no longer updated in a linear fashion, allowing for plausible nonlinearities in optimal policy. We consider in particular a class of models in which policymakers' priors about the natural rate of unemployment are diffuse in a region around the mean. When this is the case, it is optimal for policy to respond cautiously to small surprises in the observed unemployment rate, but become increasingly aggressive at the margin. These features of optimal policy match statements by Federal Reserve officials and the behavior of the Fed in the 1990s.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2005-24.

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Date of creation: 2005
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Publication status: Published in Journal of Economic Dynamics and Control, v. 30, no. 2 (February 2006) pp. 185-203
Handle: RePEc:fip:fedfwp:2005-24
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  1. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CEPR Discussion Papers 3811, C.E.P.R. Discussion Papers.
  2. Swanson, Eric T., 2006. "Optimal nonlinear policy: signal extraction with a non-normal prior," Journal of Economic Dynamics and Control, Elsevier, vol. 30(2), pages 185-203, February.
  3. Pearlman, Joseph G., 1992. "Reputational and nonreputational policies under partial information," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 339-357, April.
  4. 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.
  5. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  6. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  7. 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.
  8. Orphanides, Athanasios & Wieland, Volker, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  9. 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.
  10. Andrew J. Filardo, 1998. "New evidence on the output cost of fighting inflation," Economic Review, Federal Reserve Bank of Kansas City, issue Q III.
  11. Pearlman, Joseph & Currie, David & Levine, Paul, 1986. "Rational expectations models with partial information," Economic Modelling, Elsevier, vol. 3(2), pages 90-105, April.
  12. Laurence H. Meyer & Eric T. Swanson & Volker W. Wieland, 2001. "NAIRU uncertainty and nonlinear policy rules," Finance and Economics Discussion Series 2001-01, Board of Governors of the Federal Reserve System (U.S.).
  13. repec:cup:macdyn:v:8:y:2004:i:1:p:27-50 is not listed on IDEAS
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