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Stabilization and expectations in a state space model of interconnected economies, a dynamic panel study

  • David Kiefer
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    Carlin and Soskice (2005) advocate a 3-equation model of stabilization policy, the IS-PC-MR model. Their third equation is the monetary reaction rule MR derived by assuming that governments have performance objectives, but are constrained by an augmented Phillips curve PC. Central banks achieve their preferred outcome by setting interest rates along an IS curve. We simplify their model to 2 equations (PC and MR), developing a state space econometric specification of this solution, and adding a random walk model of unobserved potential growth. Applying this model to a panel of North Atlantic countries, we find it historically consistent with an inflation target of about 4%. Significant interdependence is found in the between-country covariance of inflation and growth shocks, but not of potential output. Beginning with the approximation that expected inflation is the most recent observation, we extend the model to introduce alternative assumptions about expectations with mixed results, support for the sticky-price model, but doubts about activist policy.

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    File URL: http://economics.utah.edu/research/publications/2011_15.pdf
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    Paper provided by University of Utah, Department of Economics in its series Working Paper Series, Department of Economics, University of Utah with number 2011_15.

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    Length: 27 pages
    Date of creation: 2011
    Date of revision:
    Handle: RePEc:uta:papers:2011_15
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    Web page: http://economics.utah.edu

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    1. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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    9. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
    10. Richard T. Froyen & Alfred V. Guender, 2007. "Optimal Monetary Policy under Uncertainty," Books, Edward Elgar, number 12510, December.
    11. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 191-205, February.
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    13. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
    14. David Kiefer, 2008. "Revealed preferences for macroeconomic stabilization," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 119-143, May.
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