Keywords: Inflation targeting, policy rules, natural rate of unemployment, natural rate of interest, misperceptions
Abstract: We examine the performance and robustness properties of
alternative monetary policy rules in the presence of structural
change that renders the natural rates of interest and unemployment
uncertain. Using a forward-looking quarterly model of the U.S.
economy, estimated over the 1969-2002 period, we show that the
cost of underestimating the extent of misperceptions regarding the
natural rates significantly exceeds the costs of overestimating
such errors. Naive adoption of policy rules optimized under the
false presumption that misperceptions regarding the natural rates
are likely to be small proves particularly costly.
Our results suggest that a simple and effective approach for
dealing with ignorance about the degree of uncertainty in
estimates of the natural rates is to adopt difference rules for
monetary policy, in which the short-term nominal interest rate is
raised or lowered from its existing level in response to inflation
and changes in economic activity. These rules do not require
knowledge of the natural rates of interest or unemployment for
setting policy and are consequently immune to the likely
misperceptions in these concepts. To illustrate the differences
in outcomes that could be attributed to the alternative policies
we also examine the role of misperceptions for the stagflationary
experience of the 1970s and the disinflationary boom of the 1990s.
Full paper (328 KB PDF)
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Last update: March 27, 2003