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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Monetary Policy with Imperfect Knowledge
Athanasios Orphanides and John C. Williams

Abstract: We examine the performance and robustness of monetary policy rules when the central bank and the public have imperfect knowledge of the economy and continuously update their estimates of model parameters. We find that versions of the Taylor rule calibrated to perform well under rational expectations with perfect knowledge perform very poorly when agents are learning and the central bank faces uncertainty regarding natural rates. In contrast, difference rules, in which the change in the interest rate is determined by the inflation rate and the change in the unemployment rate, perform well when knowledge is both perfect and imperfect.

Keywords: Natural rate of interest, natural rate of unemployment, rational expectations, learning, monetary policy rules.

Full paper (168 KB PDF)

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Last update: November 8, 2005