What if the Fed Had Been an Inflation Nutter?

A structural rational expectations model of U.S. monetary policy is used to make a counterfactual experiment of a strongly inflation averse Federal Reserve Bank. Results for U.S. interest rates, output, and inflation over 1965-1999 are discussed.

Introduction : This paper studies how U.S. output, inflation, and interest rates would have evolved 1965-1999 if the Federal Reserve Bank had been more inflation averse. This counterfactual experiment is done with a structural rational expectations macro model.Similar types of counterfactual experiments are discussed in several other papers,for instance, Clarida, Gal´ ı, and Gertler (1998), Rotemberg and Woodford (1999), and Bergvall (2000). These experiments can tell us a great deal about how monetary policy—and our models of monetary policy—works.The approach I take here has several advantages, however. First, the notion of a more inflation averse central bank is parameterized in terms of the bank’s objective function rather than in terms of a decision rule. Second, results from the experiments are shown for output and inflation (requires solving for the new rational expectations equilibrium), not just the policy instruments. Third, the results for the actual paths of output and inflation are shown, not just the implied unconditional variances.

Author: Joel Reneby,Jan Ericsson

Source: Stockholm School of Economics

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