Keywords: Policy evaluation, interest rate rules, data revisions, real-time data, optimal control, observation noise, inflation targeting.
Abstract: This paper investigates the implications of noisy information
regarding the measurement of economic activity for the evaluation
of monetary policy. A common implicit assumption in such
evaluations is that policymakers observe the current state of the
economy promptly and accurately and can therefore adjust policy
based on this information. However, in reality, decisions are
made in real time when there is considerable uncertainty about
the true state of affairs in the economy. Policy must be made
with partial information. Using a simple model of the U.S.
economy, I show that failing to account for the actual level of
information noise in the historical data provides a seriously
distorted picture of feasible macroeconomic outcomes and produces
inefficient policy rules. Naive adoption of policies identified
as efficient when such information noise is ignored results in
macroeconomic performance worse than actual experience.
When the noise content of the data is properly taken into account,
policy reactions are cautious and less sensitive to the apparent
imbalances in the unfiltered data. The resulting policy
prescriptions reflect the recognition that excessively activist
policy can increase rather than decrease economic instability.
Full paper (430 KB PDF)
| Full paper (303 KB Postscript)
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