IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

Robust monetary policy with imperfect knowledge

  • Athanasios Orphanides
  • John C. Williams

We examine the performance and robustness properties of monetary policy rules in an estimated macroeconomic model in which the economy undergoes structural change and where private agents and the central bank possess imperfect knowledge about the true structure of the economy. Policymakers follow an interest rate rule aiming to maintain price stability and to minimize fluctuations of unemployment around its natural rate but are uncertain about the economy's natural rates of interest and unemployment and how private agents form expectations. In particular, we consider two models of expectations formation: rational expectations and learning. We show that in this environment the ability to stabilize the real side of the economy is significantly reduced relative to an economy under rational expectations with perfect knowledge. Furthermore, policies that would be optimal under perfect knowledge can perform very poorly if knowledge is imperfect. Efficient policies that take account of private learning and misperceptions of natural rates call for greater policy inertia, a more aggressive response to inflation, and a smaller response to the perceived unemployment gap than would be optimal if everyone had perfect knowledge of the economy. We show that such policies are quite robust to potential misspecification of private sector learning and the magnitude of variation in natural rates.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.federalreserve.gov/pubs/feds/2007/200733/200733abs.html
Download Restriction: no

File URL: http://www.federalreserve.gov/pubs/feds/2007/200733/200733pap.pdf
Download Restriction: no

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2007-33.

as
in new window

Length:
Date of creation: 2007
Date of revision:
Handle: RePEc:fip:fedgfe:2007-33
Contact details of provider: Postal:
20th Street and Constitution Avenue, NW, Washington, DC 20551

Web page: http://www.federalreserve.gov/

More information through EDIRC

Order Information: Web: http://www.federalreserve.gov/pubs/feds/fedsorder.html

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Victor Zarnowitz & Phillip Braun, 1993. "Twenty-two Years of the NBER-ASA Quarterly Economic Outlook Surveys: Aspects and Comparisons of Forecasting Performance," NBER Chapters, in: Business Cycles, Indicators and Forecasting, pages 11-94 National Bureau of Economic Research, Inc.
  2. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July.
  3. John B. Taylor, 1998. "An Historical Analysis of Monetary Policy Rules," NBER Working Papers 6768, National Bureau of Economic Research, Inc.
  4. Bennett T. McCallum, 2001. "Should Monetary Policy Respond Strongly to Output Gaps?," American Economic Review, American Economic Association, vol. 91(2), pages 258-262, May.
  5. Orphanides, Athanasios & Williams, John C., 2004. "The decline of activist stabilization policy: Natural rate misperceptions, learning, and expectations," CFS Working Paper Series 2004/24, Center for Financial Studies (CFS).
  6. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, September.
  7. Orphanides, Athanasios & Williams, John C, 2006. "Inflation Targeting under Imperfect Knowledge," CEPR Discussion Papers 5664, C.E.P.R. Discussion Papers.
  8. Athanasios Orphanides & Simon van Norden, 1999. "The reliability of output gap estimates in real time," Finance and Economics Discussion Series 1999-38, Board of Governors of the Federal Reserve System (U.S.).
  9. Athanasios Orphanides & Richard D. Porter & David L. Reifschneider & Robert J. Tetlow & Frederico Finan, 1999. "Errors in the measurement of the output gap and the design of monetary policy," Finance and Economics Discussion Series 1999-45, Board of Governors of the Federal Reserve System (U.S.).
  10. James B. Bullard & Stefano Eusepi, 2004. "Did the Great Inflation occur despite policymaker commitment to a Taylor rule?," Working Papers 2003-013, Federal Reserve Bank of St. Louis.
  11. Orphanides, Athanasios, 2003. "Historical monetary policy analysis and the Taylor rule," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 983-1022, July.
  12. Alex Cukierman & Francesco Lippi, 2003. "Endogenous Monetary Policy with Unobserved Potential Output," CEIS Research Paper 26, Tor Vergata University, CEIS.
  13. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
  14. Smets, Frank, 2003. "Maintaining price stability: how long is the medium term?," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1293-1309, September.
  15. Carl E. Walsh, 2003. "Implications of a changing economic structure for the strategy of monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 297-348.
  16. Athanasios Orphanides, 1998. "Monetary policy evaluation with noisy information," Finance and Economics Discussion Series 1998-50, Board of Governors of the Federal Reserve System (U.S.).
  17. Andrew T.. Levin & Volker Wieland & John Williams, 1999. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Chapters, in: Monetary Policy Rules, pages 263-318 National Bureau of Economic Research, Inc.
  18. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 125-146, August.
  19. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
  20. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Working Paper Series 2002-04, Federal Reserve Bank of San Francisco.
  21. Athanasios Orphanides & John C. Williams, 2003. "Inflation scares and forecast-based monetary policy," Finance and Economics Discussion Series 2003-41, Board of Governors of the Federal Reserve System (U.S.).
  22. Clark, Todd E. & Kozicki, Sharon, 2004. "Estimating equilibrium real interest rates in real-time," Discussion Paper Series 1: Economic Studies 2004,32, Deutsche Bundesbank, Research Centre.
  23. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules Under Model Uncertainty," American Economic Review, American Economic Association, vol. 93(3), pages 622-645, June.
  24. John C. Williams, 2006. "Robust estimation and monetary policy with unobserved structural change," Economic Review, Federal Reserve Bank of San Francisco, pages 1-16.
  25. 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.
  26. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series 2003-11, Board of Governors of the Federal Reserve System (U.S.).
  27. Simon van Norden, 2002. "Filtering for Current Analysis," Staff Working Papers 02-28, Bank of Canada.
  28. Malcolm D. Knight & Chair, 2003. "Implications of a changing economic structure for the strategy of monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 361-371.
  29. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  30. 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.
  31. Gaspar, Vítor & Smets, Frank & Vestin, David, 2006. "Adaptive learning, persistence, and optimal monetary policy," Working Paper Series 0644, European Central Bank.
  32. Thomas Laubach & John C. Williams, 2001. "Measuring the natural rate of interest," Finance and Economics Discussion Series 2001-56, Board of Governors of the Federal Reserve System (U.S.).
  33. Orphanides, Athanasios, 1999. "The Quest for Prosperity Without Inflation," Working Paper Series 93, Sveriges Riksbank (Central Bank of Sweden).
  34. Leitemo, Kai & Lonning, Ingunn, 2006. "Simple Monetary Policymaking without the Output Gap," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1619-1640, September.
  35. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
  36. Gaspar, Vitor & Smets, Frank, 2002. "Monetary Policy, Price Stability and Output Gap Stabilization," International Finance, Wiley Blackwell, vol. 5(2), pages 193-211, Summer.
  37. Timothy Cogley & Thomas Sargent, . "Evolving Post-World War II U.S. Inflation Dynamics," Working Papers 2132872, Department of Economics, W. P. Carey School of Business, Arizona State University.
  38. John C. Williams, 1999. "Simple rules for monetary policy," Finance and Economics Discussion Series 1999-12, Board of Governors of the Federal Reserve System (U.S.).
  39. Stark, Tom & Croushore, Dean, 2002. "Forecasting with a real-time data set for macroeconomists," Journal of Macroeconomics, Elsevier, vol. 24(4), pages 507-531, December.
  40. Marc Giannoni & Michael Woodford, 2004. "Optimal Inflation-Targeting Rules," NBER Chapters, in: The Inflation-Targeting Debate, pages 93-172 National Bureau of Economic Research, Inc.
  41. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
  42. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
  43. John B. Taylor, 1999. "Introduction to "Monetary Policy Rules"," NBER Chapters, in: Monetary Policy Rules, pages 1-14 National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:fip:fedgfe:2007-33. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Franz Osorio)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.