We use a micro-founded macroeconometric modeling framework to investigate the design of monetary policy when the central bank faces uncertainty about the true structure of the economy. We apply Bayesian methods to estimate the parameters of the baseline specification using postwar U.S. data and then determine the policy under commitment that maximizes household welfare. We find that the performance of the optimal policy is closely matched by a simple operational rule that focuses solely on stabilizing nominal wage inflation. Furthermore, this simple wage stabilization rule is remarkably robust to uncertainty about the model parameters and to various assumptions regarding the nature and incidence of the innovations. However, the characteristics of optimal policy are very sensitive to the specification of the wage contracting mechanism, thereby highlighting the importance of additional research regarding the structure of labor markets and wage determination.

This paper develops a quantitative monetary DSGE model that allows for financial intermediaries that face endogenous balance sheet constraints. We use the model to simulate a crisis that has some basic features of the current economic downturn. We then use the model to quantitatively assess the effect of direct central bank intermediation of private lending, which is the essence of the unconventional monetary policy that the Federal Reserve has developed to combat the subprime crisis. We show numerically how central bank credit policy might help moderate the simulated crisis. We then compute the optimal degree of central bank credit intervention in this scenario and also compute the welfare gains. 1 1

We develop a canonical framework to think about credit market frictions and aggregate economic activity in the context of the current crisis. We use the framework to address two issues in particular: …rst, how disruptions in …nancial intermediation can induce a crisis that a¤ects real activity; and second, how various credit market interventions by the central bank and the Treasury of the type we have seen recently, might work to mitigate the crisis. We make use of earlier literature to develop our framework and characterize how very recent literature is incorporating insights from the crisis.

In this paper we consider the policy implications of a fully specified dynamic general equilibrium model, developed by Smets and Wouters (2003a). This is a relatively large-scale forward looking model, which was shown to provide a good fit to the data. However there has been little previous work analyzing monetary policy within such a model. We first re-examine the empirical performance of the model. We show that systematically accounting for prior uncertainty leads to substantially different parameter estimates. However many of the qualitative features of the model remain similar under the alternative estimates that we find. We then formulate and analyze optimal policy rules in the model. In addition to a standard, but ad hoc, loss function we derive and justify a utility-based loss function for the model. We determine the optimal equilibrium dynamics under both loss functions and under both sets of parameter estimates. Then we discuss alternative ways of implementing the optimal equilibrium. We find that there is much scope for indeterminacy in the model, and that optimal policy rules developed for one set of estimates may perform poorly if the economy is governed by the other set. We finally turn to the analysis of simple policy rules, finding that for the simple loss function these rules perform relatively well and are robust to different parameter estimates. Overall, our results suggest that the model may be relatively robust in its ability to capture certain aspects of the data. However some caution should be exercised in using the structural estimates, and in particular it may be dangerous to pursue fully optimal policy in such complex models. We thank Frank Smets and Raf Wouters for providing us with their data and computer programs, and for answering a number of questions about the implementation of the model. We also thank Marc Giannoni for providing us with his programs to compute optimal policy rules as in Giannoni and Woodford (2002), and we thank Mark Watson for providing the programs to replicate Stock and Watson (2003). 1 1

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Aclassicquestioninmacroeconomicsis: whatisthesizeofthegovernmentspending multiplier? There is a large empirical literature that grapples with this question. Authors such as Barro (1981) argue that the multiplier is around 0.8 while authors such as Ramey (2008) estimate the multiplier to be closer to 1.2. 1

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4 In 2007 all ECB publications feature a motif taken from the €20 banknote. This paper can be downloaded without charge from