Commentary on "Optimal monetary policy under uncertainty: a Markov jump-linear-quadratic approach"

Econometric models ; Monetary policy

The performance of forecast-based monetary policy rules under model uncertainty

We investigate the performance of forecast-based monetary policy rules using five macroeconomic models that reflect a wide range of views on aggregate dynamics. We identify the key characteristics of rules that are robust to model uncertainty: such rules respond to the one-year-ahead inflation forecast and to the current output gap and incorporate a substantial degree of policy inertia. In contrast, rules with longer forecast horizons are less robust and are prone to generating indeterminacy. Finally, we identify a robust benchmark rule that performs very well in all five models over a wide range of policy preferences

Data uncertainty and the role of money as an information variable for monetary policy

In this study, we perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area. We document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. We then proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. We show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. As a practical matter, however, we conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area

The Debt Limit: History and Recent Increases

[Excerpt] The statutory debt limit applies to almost all federal debt. The limit applies to federal debt held by the public (that is, debt held outside the federal government itself) and to federal debt held by the government’s own accounts. Federal trust funds, such as Social Security, Medicare, Transportation, and Civil Service Retirement accounts, hold most of this internally held debt. The government’s surpluses or deficits determine essentially all of the change in debt held by the public. The government’s on-budget fiscal balance, which excludes a U.S. Postal Service net surplus or deficit and a large Social Security surplus of payroll taxes net of paid benefits, does not directly affect debt held in government accounts. Increases or decreases in debt held by government accounts result from net financial flows into accounts holding the debt, such as the Social Security Trust Fund. Legal requirements and government accounting practices also affect levels of debt held by government accounts. On August 2, 2011, President Obama signed into law the Budget Control Act of 2011 (BCA; S.365), after an extended debt limit episode. The federal debt reached its statutory limit on May 16, 2011, prompting Treasury Secretary Timothy Geithner to declare a debt issuance suspension period, allowing certain extraordinary measures to extend Treasury’s borrowing capacity. The BCA included provisions aimed at deficit reduction and would allow the debt limit to rise between $2,100 billion and$2,400 billion in three stages, with the latter two subject to congressional disapproval. Two of the three increases, totaling $900 billion, have occurred, and a request for a third increase is likely to occur in mid-January 2012

The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty

In this paper, we consider whether monetary policymakers should adjust short-term nominal interest rates in response to inflation and output forecasts rather than to recent outcomes of these variables. The use of forecast-based rules has been advocated on the basis of transmission lags and other considerations, and such rules also provide a reasonably good description of the policy strategies of several inflation-targeting central banks. We address these issues using four different macro-econometric models of the U.S. economy (the Fuhrer-Moore model, the MSR model of Orphanides and Wieland, Taylor's Multi-Country Model, and the FRB/US staff model); all four models incorporate rational expectations and nominal inertia, but differ in many other respects. We begin by evaluating the performance of various forecast-based rules that have been proposed in the literature. We find that some of these rules yield relatively poor performance, and that a number of such rules fail to yield determinacy (that is, a unique rational expectations equilibrium) in at least one of the four models. Next, we determine the optimal set of forecast-based rules for each model (that is, the rules that trace out the inflation-output volatility frontier subject to an upper-bound on interest rate volatility). We find that even optimized forecast-based rules yield very small benefits compared with optimized outcome-based rules that respond to current inflation, the current output gap, and the lagged interest rate. In the case of rules that respond directly to inflation forecasts but not to the output gap, we find a substantial deterioration in performance, even as measured by a policymaker whose sole objective is to minimize inflation variability. Finally, rules that involve relatively short forecast horizons (less than one year ahead) are reasonably robust to model uncertainty; that is, when such a rule is optimized for one model, the rule also performs reasonably well in the other three models. However, rules that respond to longer-horizon forecasts are not robust to model uncertainy (and in some cases yield indeterminacy), mainly because of the sharp differences in output and inflation persistence across the four models considered here.

Identifying the influences of nominal and real rigidities in aggregate price-setting behavior

We formulate a generalized price-setting framework that incorporates staggered contracts of multiple durations and that enables us to directly identify the influences of nominal vs. real rigidities. Using German macroeconomic data over the period 1975Q1 through 1998Q4 toestimate this framework, we find that the data is well-characterized by a truncated Calvostyle distribution with an average duration of about two quarters. We also find that new contracts exhibit very low sensitivity to marginal cost, corresponding to a relatively high degree of real rigidity. Finally, our results indicate that backward-looking behavior is not needed to explain the aggregate data, at least in an environment with a stable monetary policy regime and a transparent and credible inflation objective. JEL Classification: E31, E52Inflation persistence, nominal rigidity, overlapping contracts, real rigidity, simulation-based indirect inference

Inflation persistence and monetary policy design: an overview

How monetary policy should be set optimally when the structure of the economy exhibits inflation persistence is an important question for policy makers. This paper provides an overview of the implications of inflation persistence for the design of monetary policy. JEL Classification: E52, E58Inflation persistence, optimal monetary policy, uncertainty

Relative Price Distortion and Optimal Monetary Policy in Open Economies

This paper addresses three issues on the conduct of monetary policy in open economies on the basis of a two-country model with Calvo-type sticky prices. Is the isomorphism of the optimal policy problems between closed and open economies robust to whether the foreign country is buffeted by cost-push shocks? How can we obtain a linear quadratic approximation that replicates the key results of the original optimal policy problem, especially when there is an analytical solution to the original problem in the presence of initial price dispersion? What are optimal policy recommendations for the central banks in open economies when both cost-push shock and initial price dispersion exist?Cost-Push Shocks, Relative Price Distortion, Interdependence, Open Economy, Optimal Policy

The magnitude and Cyclical Behavior of Financial Market Frictions

We analyze a new panel data set that includes balance sheet information, measures of expected default risk, and credit spreads on publicly-traded debt for more than 900 firms over the period 1997Q1 through 2003Q3. We obtain precise time-specific estimates of the financial frictions parameter underlying the benchmark financial accelerator model of Bernanke, Gertler, and Gilchrist (1999) and clearly reject the null hypothesis of no credit market imperfections; furthermore, for the expansionary period through mid-2000, these estimates are quite similar to the calibrated values used in previous research. Finally, we find that financial market frictions exhibit strong cyclical pattern, with parameter estimates rising by a factor of two during the latest economic downturn before returning to pre-recession levels in 2003.perturbation, policy