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Central Bank Policy Rules: Conceptual Issues and Practical Considerations

  • Stephen G. Cecchetti

The design of rules for central bank policy has been a subject of increasing interest to many monetary economists. The purpose of this essay is first to present an analytical structure in which a policymaker is presumed to formulate a rule based on the solution to an optimal control problem, and then to examine a number of issues that are germane to the current debate on the nature of such rules. These issues include the implication for policymaking of the slope of the output-inflation variability frontier, the importance of various types of uncertainty, the consequences of a zero nominal interest rate floor, and the possible reasons for interest rate smoothing. Although this essay is intended to raise, rather than resolve, key questions concerning policy rules, it does offer fairly compelling evidence on one point. This concerns the potential consequences of the move by many central banks toward some form of price-level or inflation targeting. In adopting this approach, central banks are implicitly changing the relative importance of output and inflation variability in their objective function. The robustness of the policy rule, however, may depend on the shape of the output-inflation variability trade-off. The data indicate that this trade-off is extremely steep: small decreases in inflation variability are associated with very large increases in output variability. This finding suggests that pure inflation targeting may have very undesirable side effects.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6306.

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Date of creation: Dec 1997
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Publication status: published as Cecchetti, Stephen G. "Policy Rules And Targets: Framing The Central Banker's Problem," FRB New York- Economic Policy Review, 1998, v4(2,Jun), 1-14.
Handle: RePEc:nbr:nberwo:6306
Note: ME
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  1. Frederic S. Mishkin & Adam S. Posen, 1998. "Inflation Targeting: Lessons from Four Countries," NBER Working Papers 6126, National Bureau of Economic Research, Inc.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
  3. Lars E. O. Svensson, 1996. "Price Level Targeting vs. Inflation Targeting: A Free Lunch?," NBER Working Papers 5719, National Bureau of Economic Research, Inc.
  4. Cukierman, Alex & Kalaitzidakis, Pantelis & Summers, Lawrence H. & Webb, Steven B., 1993. "Central bank independence, growth, investment, and real rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 95-140, December.
  5. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  6. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
  7. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  8. Ball, Laurence, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
  9. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," NBER Working Papers 5893, National Bureau of Economic Research, Inc.
  10. Alesina, Alberto & Summers, Lawrence H, 1993. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(2), pages 151-62, May.
  11. Matthew D. Shapiro & David W. Wilcox, 1996. "Mismeasurement in the Consumer Price Index: An Evaluation," NBER Working Papers 5590, National Bureau of Economic Research, Inc.
  12. Erica L. Groshen & Mark E. Schweitzer, 1997. "Identifying inflations grease and sand effects in the labor market," Working Paper 9705, Federal Reserve Bank of Cleveland.
  13. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  14. Martin Feldstein & James H. Stock, 1994. "The Use of a Monetary Aggregate to Target Nominal GDP," NBER Chapters, in: Monetary Policy, pages 7-69 National Bureau of Economic Research, Inc.
  15. Stephen G. Cecchetti, 1995. "Inflation Indicators and Inflation Policy," NBER Working Papers 5161, National Bureau of Economic Research, Inc.
  16. George A. Akerlof & William R. Dickens & George L. Perry, 1996. "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1), pages 1-76.
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