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)| false Isard, Peter, and Douglas Laxton, 1998, “ Monetary Policy with NAIRU Uncertainty and Endogenous Credibility: Perspectives on Policy Rules and the Gains from Experimentation and Transparency,” forthcoming in Reserve Bank of New Zealand Conference Volume on Monetary Policy Under Uncertainty.
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This paper will be published in International Finance and Financial Crises: Essays in Honor of Robert P. Flood Jr., ed. by Peter Isard, Assaf Razin, and Andrew K. Rose (Washington: International Monetary Fund and Boston: Kluwer Academic Publishers), forthcoming 1999. An earlier draft was prepared for the January 15–16, 1999 conference at the International Monetary Fund in celebration of the contributions of Robert Flood. The first two authors are with the Research Department of the IMF. The third author is at the Stockholm School of Economics. The views expressed are those of the authors and do not necessarily reflect the views of the International Monetary Fund. We thank Jeffrey Fuhrer, Lars Svensson, Robert Tetlow, and Volker Wieland for useful discussions and Susanna Mursula and Sarma Jayanthi for extensive research assistance.
Losses associated with interest rate variability are reflected in the policy objective function, however, and thereby influence the optimal calibration of the policy reaction function.
The terminology emanated from Persson and Tabellini (1990).
Recent examples of such papers were included in the programs of the NBER Conference on Monetary Policy Rules (January 15–17, 1998), the Federal Reserve Bank of San Francisco Conference on Central Bank Inflation Targeting (March 6–7, 1998), the Riksbank-IIES Conference on Monetary Policy Rules (June 12–13, 1998), the 1998 Symposium on Computational Economics at Cambridge University (June 29–July 1, 1998), and the Reserve Bank of New Zealand Conference on Monetary Policy Under Uncertainty (June 29–July 3, 1998). Earlier contributions to the inflation targeting literature include the conference volumes Leiderman and Svensson (1995), Haldane (1995), Federal Reserve Bank of Kansas City (1996), and Lowe (1997).
A crucial prerequisite for exercising discretion intelligently, of course, is that the monetary authorities must understand the time-consistency issue and continuously evaluate the extent to which their behavior may be affecting the credibility of their announced objectives.
In this context, Svensson argues that the strategy of inflation targeting can be viewed as a way of committing to minimize a particular loss function by adopting a rule (first-order condition) that involves target variables or forecasts of target variables and by implementing communication practices that allow the public to evaluate the monetary authority’s performance and hold it accountable.
Data uncertainties, which also have implications for the optimal strength of policy reactions, are not addressed in this paper; see Orphanides (1998) for a recent exploration of this topic. On the general importance of changing the strength of policy responses when the (perceived) macro model changes, see Amano, Coletti, and Macklem (1998).
See, for example, the Symposium comprised of Blanchard and Katz (1997), Galbraith (1997), Gordon (1997), Rogerson (1997), Staiger, Stock, and Watson (1997), and Stiglitz (1997), as published in the Winter 1997 issue of the Journal of Economic Perspectives.
Other recent analyses of the implications of NATRU uncertainty (or output gap uncertainty) include Wieland (1998) and Smets (1998), who use simple linear models with backward-looking expectations to demonstrate that uncertainty about the NAIRU (or about the Phillipscurve parameters on which NAIRU estimates depend) provides a motive for cautious policy reactions.
Williams (1999) finds that even in models with hundreds of state variables, parsimonious specifications of simple policy rules appear to be very effective in achieving stabilization objectives. See also Rudebusch and Svensson (1998).
The model contains important backward- and forward-looking components, as derived from the bargaining framework in Fuhrer and Moore (1995a, 1995b), but the functional form is less restrictive and is more consistent with empirical evidence that suggests that there is a small weight on the “rational” or forward-looking component of the US inflation process—for example, see Fuhrer (1997).
The base-case model variant assumes N=12, but to explore the sensitivity of the results to the length of contracts we have also conducted simulations with N=4.
In equations (1) and (2), the estimated value of γ is 3.20. The estimation and stochastic simulations are based on the assumption that φt = max[0, ut* − 4], and
The latter would be implied by constant adherence to a given policy rule. Note that equation (7) is relevant for interpreting history and updating estimates of the NATRU, but that apart from assuming stationarity, we do not require specific assumptions about the distribution of the ϵtu terms, which are not drawn directly in the simulation analysis.
Kuttner (1992, 1994) has applied this idea to measuring potential output. In using information about the error terms in each of the two Phillips curves, our procedure for estimating the NAIRU and DNAIRU essentially gives equal weight to the data on the CPI and the CPI excluding food and energy.
The simulations set
Estimates of equations based on the Michigan survey measures of inflation expectations suggested a weight of .6 on the model consistent component, but there was significant evidence of residual autocorrelation in the estimated equations.
Fuhrer and Moore (1995b) argue that longer-term interest rates are more relevant for explaining aggregate demand and unemployment. The implications of such an alternative representation of the monetary transmission mechanism might be interesting to explore as an extension of the analysis in this paper.
The qualitative results and main conclusions of this paper do not hinge on the precise nature of the unemployment dynamics, although they clearly depend on a positive response of unemployment to the real interest rate, as well as on the existence of both lags in the response of unemployment to policy actions and a persistent component of unemployment. It might be interesting, in future work, to consider modifications of the model in which the response of unemployment to the interest rate was forward looking. It might also be interesting to treat the parameters of the unemployment equation as an additional element of uncertainty—along with the level of the NAIRU—that policymakers take into account when choosing the “optimal calibration” for a policy rule.
Interest in this formulation received considerable impetus from Taylor (1993), who defined his rule in terms of the output gap. Recent studies of the performance of Taylor rules can be found, for example, in Levin, Wieland, and Williams (1998) and Taylor (1998a).
Appendix II discusses the stability conditions for models that are based on linear and nonlinear Phillips curves and explains why the conventional Taylor rule ensures stability in models with linear Phillips curves but does not ensure stability in nonlinear models of the inflation process.
Different types of IFB rules have been shown to deliver reasonable economic performances over a wide range of disturbances; see, for example, Amano, Coletti, and Macklem (1998), Haldane and Batini (1998), and Rudebusch and Svensson (1998).
The β parameter also provides a basis for analyzing the pros and cons of central bank transparency. As Faust and Svensson (1998) emphasize, transparency about the central bank’s objectives, by improving the accuracy of the public’s information about β (or alternatively, about the difference between ut* - β and the long-run DNAIRU, u*), can make it possible for the public to distinguish more accurately between the intended components of macroeconomic outcomes and the central bank’s control errors, thereby making the central bank’s reputation and credibility more sensitive to its actions.
The stochastic simulations were performed using a robust and efficient Newton-Raphson simulation algorithm that is now available in portable TROLL—for a discussion of the properties of this algorithm see Juillard and others (1998).
The setting ν=0.5 corresponds to the base-case value used by Rudebusch and Svensson (1998). Note also that the setting of β is irrelevant when θ = 0.
Clarida, Gali, and Gertler (1998) consider specifications based, alternatively, on output gaps and unemployment gaps. The CGG rule is derived by combining the following two equations
where rst* represents a target nominal interest rate. Thus, the constant term in equation (19) can be decomposed into c = r*−(β − 1)πTAR.
Clarida, Gali, and Gertler (1998) also suggest that it is more consistent with actual Fed behavior for the interest rate reaction function to depend upon the one or two-quarter ahead forecast of the unemployment gap rather than the contemporaneous unemployment gap. It would be interesting to further explore the stabilizing properties of CGG rules to see if they change significantly when the rule is based on forecasts of the unemployment gap rather than contemporaneous measures.
It may be noted here that the literature has distinguished between IFB rules that embody rule-consistent inflation forecasts, as does our IFB2 rule, and IFB rules defined in terms of constant-interest-rate inflation forecasts.
We did not undertake an extensive search for the optimal inflation forecast horizon but note that three quarters is roughly half the time that is generally believed to be required for interest rates to have their full effects on the economy. By comparison, Clarida, Gali, and Gertler (1998) use a four-quarter-ahead inflation forecast, while Haldane and Batini (1998) and Rudebusch and Svensson (1998) explore the performances of IFB rules with a range of forecast horizons.
Svensson (1999) suggests that a two-year horizon might be preferable on conceptual grounds, reflecting his notion (perhaps inferred from models with substantial inflation inertia) that inflation forecasts at shorter horizons have significant predetermined components. This suggestion seems to reflect a preference for rules that (approximately) correspond to the first-order conditions from policy optimization problems, along with the notion that such first-order conditions boil down to simpler expressions of the relationship between the interest rate and an inflation forecast when the inflation forecast is not largely predetermined.
In a separate forthcoming paper we argue that the high estimates of ρ (and associated high t-statistics) that are obtained when CGG rules are fitted to historical data are probably reflections of specification error.
We chose this model because it was more easily accessible than the other models considered by Levin, Wieland, and Williams (1998). We are indebted to Jeffrey Fuhrer for taking the time to help us replicate some of his earlier results. The results reported in this appendix have been derived from the parameter estimates reported in Fuhrer and Moore (1995b).
Our line of argument in this appendix is broadly similar to the one presented in Christiano and Gust (1999), who show not only that poorly parameterized simple rules can give rise to poor simulation properties in their particular model, but also that choosing the parameters of rules on the basis of one particular class of models can give rise to indeterminacy or explosiveness in other models.
It is convenient here to follow Taylor (1993) in defining the rule in terms of the output gap rather than the unemployment gap. For notational convenience we have dropped the constant term in the equation by assuming that the equilibrium real interest rate and long-run inflation target are zero.
For example, the long-run effects of a permanent unitary change in the output gap is equal to the short-run effect, (1 - ρ)wy, divided by (1 - ρ).
Under the global linearity assumption, the estimated slope of the Phillips curve (based on post war U.S. data) suggests that unemployment gaps or output gaps have small effects on the inflation process. These small effects imply that it can be very costly, in the context of these models, to reduce inflation once high inflation expectations have become entrenched. The estimated slope also means that for given inflation expectations, the marginal effect on inflation of an increase in excess demand is small, even when the level of excess demand is high.