In this paper, we investigate the properties of alternative monetary policy rules using four structural macroeconometric models: the Fuhrer-Moore model, Taylor’s Multi-Country Model, the MSR model of Orphanides and Wieland, and the FRB staff model. All four models incorporate the assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in many other respects (e.g., the dynamics of prices and real expenditures). We compute the output-inflation volatility frontier of each model for alternative specifications of the interest rate rule, subject to an upper bound on nominal interest rate volatility. Our analysis provides strong support for rules in which the first-difference of the federal funds rate responds to the current output gap and the deviation of the one-year average inflation rate from a specified target. In all four models, first-difference rules perform much better than rules of the type proposed by Taylor (1993) and Henderson and McKibbin (1993),

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.

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...

this paper was presented at Bank of Japan's Ninth International Conference, "The Role of Monetary Policy under Low Inflation: Deflationary Shocks and Their Policy Responses," held in Tokyo, July 3--4, 2000. I thank my discussants, Glenn Stevens and Job Swank, and Claes Berg, Ben Bernanke, Peter Bofinger, Guy Debelle, Stefan Gerlach, Charles Goodhart, Koichi Hamada, Dale Henderson, Takatoshi Ito, Bennett McCallum, Allan Meltzer, Edward Nelson, Christian Pfister, Georg Rich, John Rogers, Shigenori Shiratsuka, Christopher Sims, Frank Smets, Peter Tinsley, Michael Woodford, and participants of the NBER Summer Institute for useful discussions and comments; Annika Andreasson and Christina Lnnblad for editorial and secretarial assistance; and the Department of Economics and the International Finance Section at Princeton University for its hospitality during my visit 1999--2000. I am solely responsible for expressed views and any errors. I. Introduction For several decades, h

This paper examines the implications of recent research on monetary policy rules for practical monetary policy making, with special emphasis on strategies for setting interest rates by the European Central Bank (ECB). The paper draws on recent research and new simulations of a large open economy model to assess the efficiency of a simple benchmark rule in comparison with other proposed rules. The paper stresses new results on the robustness of monetary policy rules in which each rule that is optimal or good according to one model or researcher is tested for robustness by other researchers using different models. Because of the large increase in the number of economists focussing on econometric evaluation of monetary policy rules for the interest rate instrument and because of the parallel increase in the variety of models being developed for this purpose, much more evidence is becoming available on the robustness of simple monetary policy rules for the interest rate than ever before.

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The Federal Reserve and other central banks tend to change short-term interest rates in sequences of small steps in the same direction and reverse the direction of interest rate movements only infrequently. These characteristics, often referred to as interest-rate smoothing, have led to criticism that policy responds too little and too late to macroeconomic developments, suggesting to some observers that the Federal Reserve has an objective of minimizing interest- rate volatility. This paper, however, argues that interest-rate smoothing may well represent optimal behavior on the part of central banks whose only objectives are to stabilize output and inflation. We present empirical results from several recent papers that offer three explanations of interest-rate smoothing: forward-looking behavior by market participants, measurement error associated with key macroeconomic variables, and uncertainty regarding relevant structural parameters.

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In this paper we estimate a small model of the euro area to be used as a laboratory for evaluating the performance of alternative monetary policy strategies. We start with the relationship between output and inflation and investigate the fit of the nominal wage contracting model due to Taylor (1980)and three different versions of the relative real wage contracting model proposed by Buiter and Jewitt (1981)and estimated by Fuhrer and Moore (1995a) for the United States. While Fuhrer and Moore reject the nominal contracting model in favor of the relative contracting model which induces more inflation persistence, we find that both models fit euro area data reasonably well. When considering France, Germany and Italy separately, however, we find that the nominal contracting model fits German data better, while the relative contracting model does quite well in countries which transitioned out of a high inflation regime such as France and Italy. We close the model by estimating an aggregate demand relationship and investigate the consequences of the different wage contracting specifications for the inflation-output variability tradeoff, when interest rates are set according to Taylor’s rule.

∗ Preliminary draft. Prepared for the November 2002 Carnegie-Rochsester conference. [Thanks.] The opinions expressed are those of the author and do not necessarily reflect views of the Board of Governors of the Federal Reserve System. 1