During the past 20 years, the world’s major central banks have been largely successful at bringing inflation under control. Although it is premature to suggest that inflation is no longer an issue of great concern, it is quite conceivable that the next battles facing central bankers will lie on a different front. One development that has already concentrated the minds of policymakers is an apparent increase in financial instability, of which one important dimension is increased volatility of asset prices. Borio, Kennedy, and Prowse (1994), among others, document the emergence of major boom-bust cycles in the prices of equity and real estate in a number of industrialized countries during the 1980s. Notable examples include the United States,

The paper extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand with some microfoundations, and with stylized realistic lags in the different transmission channels for monetary policy. The paper compares targeting of CPI and domestic inflation, strict and exible inflation targeting, and inflation-targeting reaction functions and the Taylor rule. The optimal monetary policy response to several different shocks is examined. Flexible CPI-inflation targeting stands out as successful in limiting not only the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Somewhat counter to conventional wisdom, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model gives limited support for a so-called monetary conditions index, MCI, of the monetary-policy impact on aggregate d...

We examine to what extent variants of inflation-forecast targeting can avoid stabilization bias, incorporate history-dependence, and achieve determinacy of equilibrium, so as to reproduce a socially optimal equilibrium. We also evaluate these variants in terms of the transparency of the connection with the ultimate policy goals and the robustness to model perturbations. A suitably designed inflation-forecast targeting rule can achieve the social optimum and at the same time have a more transparent connection to policy goals and be more robust than competing instrument rules.

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.

It is argued that inflation targeting is best understood as a commitment to a targeting rule rather than an instrument rule, eitherageneral targeting rule (explicit objectives for monetary policy) or a specific targeting rule (a criterion for (the forecasts of) the target variables to be fulfilled), essentially the equality of the marginal rates of transformation and substitution between the target variables. Targeting rules allow the use of judgment and extramodel information, are more robust and easier to verify than optimal instrument rules, and they can nevertheless bring the economy close to the socially optimal equilibrium.

The optimal weights on indicators in models with partial information about the state of the economy and forward-looking variables are derived and interpreted, both for equilibria under discretion and under commitment. An example of optimal monetary policy with a partially observable potential output and a forward-looking indicator is examined. The optimal response to the optimal estimate of potential output displays certainty-equivalence, whereas the optimal response to the imperfect observation of output depends on the noise in this observation.

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In recent years, activist monetary policy rules responding to inflation and the level of economic activity have been advanced as a means of achieving effective output stabilization without inflation. Advocates of such policies suggest that their flexibility may yield substantial stabilization benefits while avoiding the excesses of overzealous discretionary fine-tuning such as is thought to characterize the experience of the 1960s and 1970s. In this paper, I demonstrate that these conclusions are misguided. To illustrate this fact, I construct a database with data available to policymakers in real time from 1965 to 1993 and, using an estimated model, I perform counterfactual simulations under alternative informational assumptions regarding the knowledge policymakers can reasonably have had about the state of the economy when policy decisions were made. Using realistic informational assumptions overturns findings favoring activist policies in favor of prudent policies that ignore short-run stabilization concerns altogether. The evidence points to misperceptions of the economy’s productive capacity

In May 2000, the Treasurer/Minister of Finance invited me to review the operation of monetary policy in New Zealand and provided me with the Terms of Reference. In undertaking the review, I have read the wide range of submissions provided to me and have met with a number of submitters and other interested parties. I visited New Zealand for two weeks in November 2000 in order to observe the operations of the Reserve Bank …rst hand and collect material for the review. I have also had discussions with a number of key people in the area of monetary policy from other countries. In order to judge whether the operation of monetary policy has been e¤ective, it is important to understand what monetary policy can and cannot do. People typically ask too much of monetary policy—no less in New Zealand than elsewhere. In the long term, monetary policy can only control nominal variables such as in‡ation and the nominal exchange rate. It is beyond the capacity of any central bank to increase the average level or the growth rate of real variables such as GDP and employment, or to a¤ect the average level of the real exchange rate. At best monetary policy can reduce the variability of these real variables somewhat. An attempt to increase the average level or growth rate of GDP or employment would trigger ever-rising

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