“Having looked at monetary policy from both sides now, I can testify that central banking in practice is as much art as science. Nonetheless, while practicing this dark art, I have always found the science quEite useful.” 2 Alan S. Blinder

The zero lower bound on nominal interest rates constrains the central bank's ability to stimulate the economy during downturns. We use the FRB/US model to quantify the effects of the bound on macroeconomic stabilization and to explore how policy can be designed to minimize these effects. During particularly severe contractions, open-market operations alone may be insufficient to restore equilibrium; some other stimulus is needed. Abstracting from such rare events, if policy follows the Taylor rule and targets a zero inflation rate, there is a significant increase in the variability of output but not inflation. However, a simple modification to the Taylor rule yields a dramatic reduction in the detrimental effects of the zero bound. Keywords: monetary policy, macroeconometric models, liquidity trap 1 We would like to thank Marvin Goodfriend, Donald Kohn, David Lebow, Brian Madigan, Athanasios Orphanides, Michael Prell, David Small, David Stockton, Peter Tinsley, Volker Wiela...

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This paper extends the analysis of price level targeting to a model including the NewKeynesian Phillips Curve. We examine the inflation-output variability tradeoffs implied by optimal inflation and price level rules. In previous work with the Neoclassical Phillips Curve, we found that the choice between inflation targeting and price level targeting depended on the amount of persistence in the output gap. That is, if the output gap was not too persistent, or if lagged output did not enter the aggregate supply function, then inflation targets were preferred to price level targets. When we start with a New Keynesian Phillips Curve, the amount of persistence in the output gap still affects the relative placement of the inflation-output variability tradeoff. But, contrary to the Neoclassical case, even where the persistence of the output gap in the aggregate supply function is small or nonexistent, the price level targeting regime still results in a more favorable tradeoff between output an...

The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. iii Contents

This paper considers the monetary policymaker’s joint problem of model estimation and the design of a policy rule in the face of uncertainty regarding the process of structural change in the economy. Unobserved structural change is modeled through time variation in the natural rates of interest and unemployment. I show that certainty-equivalent optimal policies perform poorly when there is uncertainty about the natural rate processes. I then examine the properties of combined estimation methods and policy rules that are robust to this type of model uncertainty. I find that weighted sample means are robust estimators of natural rates for the purpose of setting policy. The optimal policy under uncertainty incorporates a significant degree of policy inertia and a muted response to the perceived unemployment gap; by comparison, the certainty-equivalent optimized policy in this model exhibits little policy inertia and a more aggressive response to the unemployment gap. This robust estimation/policy combination is shown to be highly effective at mitigating the effects of natural rate mismeasurement.

Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada or to the Banco de Portugal. Acknowledgements

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In 2006 all ECB publications will feature a motif taken from the €5 banknote. This paper can be downloaded without charge from