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Monetary Policy with Judgment: Forecast Targeting

  • Svensson, Lars 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 U.S. 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 University Library of Munich, Germany in its series MPRA Paper with number 819.

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Date of creation: 08 Feb 2005
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Publication status: Published in International Journal of Central Banking Number 1.Volume(2005): pp. 1-54
Handle: RePEc:pra:mprapa:819
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  1. Svensson, Lars E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Seminar Papers 646, Stockholm University, Institute for International Economic Studies.
  2. 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.).
  3. Bennett T. McCallum & Edward Nelson, 2005. "Targeting versus instrument rules for monetary policy," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 597-612.
  4. Lindé, Jesper, 2001. "Estimating New-Keynesian Phillips Curves: A Full Information Maximum Likelihood Approach," Working Paper Series 129, Sveriges Riksbank (Central Bank of Sweden), revised 30 Apr 2001.
  5. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
  6. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  7. Svensson, Lars & Woodford, Michael, 2000. "Indicator Variables for Optimal Policy," Seminar Papers 688, Stockholm University, Institute for International Economic Studies.
  8. 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.
  9. Alan Greenspan, 2004. "Risk and Uncertainty in Monetary Policy," American Economic Review, American Economic Association, vol. 94(2), pages 33-40, May.
  10. Glenn D. Rudebusch, 1990. "Trends and random walks in macroeconomic time series: a re-examination," Working Paper Series / Economic Activity Section 105, Board of Governors of the Federal Reserve System (U.S.).
  11. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  12. Marcet, A. & Marimon, R., 1998. "Recursive Contracts," Economics Working Papers eco98/37, European University Institute.
  13. repec:cup:cbooks:9780521104609 is not listed on IDEAS
  14. 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.
  15. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  16. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  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.
  18. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
  19. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  20. 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.
  21. 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.
  22. 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.
  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. 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.
  25. 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.
  26. 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..
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