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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. 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.
  2. Orphanides, Athanasios, 2003. "Historical monetary policy analysis and the Taylor rule," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 983-1022, July.
  3. 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.
  4. Cukierman, Alex & Miller, Geoffrey P. & Neyapti, Bilin, 2002. "Central bank reform, liberalization and inflation in transition economies--an international perspective," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 237-264, March.
  5. 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.).
  6. Rudebusch, Glenn D., 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 0014, European Central Bank.
  7. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  8. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  9. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  10. Kevin J. Lansing, 2000. "Learning about a shift in trend output: implications for monetary policy and inflation," Proceedings, Federal Reserve Bank of San Francisco.
  11. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  12. Svensson, Lars E O, 1998. "Inflation Targeting as a Monetary Policy Rule," CEPR Discussion Papers 1998, C.E.P.R. Discussion Papers.
  13. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," NBER Working Papers 2737, National Bureau of Economic Research, Inc.
  14. Lars E.O. Svensson & Michael Woodford, 2004. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Chapters, in: The Inflation-Targeting Debate, pages 19-92 National Bureau of Economic Research, Inc.
  15. 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.).
  16. 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.
  17. Orphanides, Athanasios, 2000. "The quest for prosperity without inflation," Working Paper Series 0015, European Central Bank.
  18. Lars Peter Hansen & Thomas J. Sargent, 1990. "Recursive Linear Models of Dynamic Economies," NBER Working Papers 3479, National Bureau of Economic Research, Inc.
  19. 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.
  20. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, September.
  21. Kenneth Kuttner, 1992. "Monetary policy with uncertain estimates of potential output," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jan, pages 2-15.
  22. repec:cup:cbooks:9780521780254 is not listed on IDEAS
  23. Ehrmann, M. & Smets, F., 2001. "Uncertain Potential Output: Implications for Monetary Policy," Papers 59, Quebec a Montreal - Recherche en gestion.
  24. 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.
  25. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  26. 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.
  27. 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.
  28. 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.
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