The Federal Reserve Board eagle logo links to home page
Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page Simple Rules for Monetary Policy
John C. Williams

Abstract: What is a good monetary policy rule for stabilizing the economy? In this paper, efficient policy rules are computed using the FRB/US large-scale open-economy macroeconometric model. Simple three-parameter policy rules are found to be very effective at minimizing fluctuations in inflation, output, and interest rates: Increases in rule complexity yield only trivial reductions in aggregate variability. Under rational expectations, efficient policies smooth the interest rate response to shocks and use the feedback from anticipated policy actions to stabilize inflation and output and to moderate movements in short-term interest rates. Policy should react to a multi-period inflation rate rather than the current quarter inflation rate; in fact, targeting the price level, as opposed to the inflation rate, involves only small additional stabilization costs. These results are robust to parameter and model uncertainty and the imposition of the non-negativity constraint on nominal interest rates. However, if expectations formation is invariant to policy, as in backward-looking models, the expectations channel is shut off and the performance of policies that are efficient under rational expectations may, as a result, deteriorate markedly; efficient policies, in contrast, exploit systematic expectational errors.

Keywords: Monetary policy rules, macroeconometric models, rational expectations

Full paper (280 KB PDF) | Full paper (711 KB Postscript)

Home | Economic research and data | FR working papers | FEDS | 1999 FEDS papers
To comment on this site, please fill out our feedback form.
Last update: March 25, 1999