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Endogenous Monetary Policy with Unobserved Potential Output

  • Alex Cukierman

    ()

    (Tel Aviv University - Eitan Berglas School of Economics)

  • Francesco Lippi

    ()

    (Bank of Italy - Research Department)

This paper characterizes endogenous monetary policy when policymakers are uncertain about the extent to which movements in output and inflation are due to changes in potential output or to cyclical demand and cost shocks. We refer to this informational limitation as the "information problem" (IP). Main results of the paper are: 1. Policy is likely to be excessively loose (restrictive) for some time when there is a large decrease (increase) in potential output in comparison to a full information benchmark. This provides a partial but unified explanation for the inflation of the seventies and the price stability of the nineties. 2. Errors in forecasting potential output and the output gap are generally serially correlated. 3. A quantitative assessment, based on an empirical model of the US economy developed by Rudebusch and Svensson (1999) indicates that, during and following periods of large changes in potential output, the IP significantly affects the dynamics of inflation and output. 4. The increase in the Fed's conservativeness between the seventies and the nineties, and a more realistic appreciation of the uncertainties surrounding potential output in the second period, imply that the IP problem had a stronger impact in the seventies than in the nineties.

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Paper provided by Tor Vergata University, CEIS in its series CEIS Research Paper with number 26.

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Length: 44
Date of creation: 30 Nov 2003
Date of revision:
Handle: RePEc:rtv:ceisrp:26
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  1. 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.
  2. 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.
  3. 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.
  4. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  5. Kenneth Kuttner, 1992. "Monetary policy with uncertain estimates of potential output," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jan, pages 2-15.
  6. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
  7. Rudebusch, Glenn D., 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 0014, European Central Bank.
  8. Orphanides, Athanasios, 1999. "The Quest for Prosperity Without Inflation," Working Paper Series 93, Sveriges Riksbank (Central Bank of Sweden).
  9. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
  10. Michael Ehrmann and Frank Smets, 2001. "Uncertain Potential Output: Implications for Monetary Policy," Computing in Economics and Finance 2001 8, Society for Computational Economics.
  11. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June.
  12. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
  13. Eric T. Swanson, 2000. "On signal extraction and non-certainty-equivalence in optimal monetary policy rules," Finance and Economics Discussion Series 2000-32, Board of Governors of the Federal Reserve System (U.S.).
  14. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.).
  15. Blanchard, Olivier Jean & Quah, Danny, 1989. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," American Economic Review, American Economic Association, vol. 79(4), pages 655-73, September.
  16. Svensson, Lars & Woodford, Michael, 2000. "Indicator Variables for Optimal Policy," Seminar Papers 688, Stockholm University, Institute for International Economic Studies.
  17. Cukierman, A. & Miller, G.P. & Neyapti, B., 2000. "Central Bank Rerform, Liberalization and Inflation in Transition Economies - an International Perspective," Papers 00-19, Tel Aviv.
  18. Taylor, J.B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by European Central Bank," Papers 649, Stockholm - International Economic Studies.
  19. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  20. Kevin J. Lansing, 2000. "Learning about a shift in trend output: implications for monetary policy and inflation," Proceedings, Federal Reserve Bank of San Francisco.
  21. Gerali, Andrea & Lippi, Francesco, 2003. "Optimal Control and Filtering in Linear Forward-looking Economies: A Toolkit," CEPR Discussion Papers 3706, C.E.P.R. Discussion Papers.
  22. Brunner, Karl & Cukierman, Alex & Meltzer, Allan H., 1980. "Stagflation, persistent unemployment and the permanence of economic shocks," Journal of Monetary Economics, Elsevier, vol. 6(4), pages 467-492, October.
  23. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  24. Lars Peter Hansen & Thomas J. Sargent, 1990. "Recursive Linear Models of Dynamic Economies," NBER Working Papers 3479, National Bureau of Economic Research, Inc.
  25. repec:cup:cbooks:9780521780254 is not listed on IDEAS
  26. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  27. Kuttner, Kenneth N, 1994. "Estimating Potential Output as a Latent Variable," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 361-68, July.
  28. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, August.
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