The Role of Policymakers in Business Cycle Fluctuations

Abstract

This paper examines the role of a policymaker in macroeconomic outcomes. To determine the possible trade-offs posed by various policy targets, we link a well-known aggregate supply function with a policy rule. In our model we determine the conditions and explore the possibility under which a policy tack that targets inflation stability, output stability, or both, can achieve success. The role of the policymaker centers on using policy rule targets in a countercyclical manner to encourage efficient business cycle outcomes (inflation and output stability). We find that there is a range of inflation and output target weights that simultaneously stabilize inflation and output. We call this condition, produced by these weights, inflation-output co-stabilization (IOCS). Outside this feasible range of inflation and output target weights there is an increase in emphasis on an inflation (output) target that destabilizes output (inflation). As demand shock variability increases, there is a broader range for the policy rule weights to be IOCS. However, we also find that supply shock variability has the opposite effect: Larger supply shock variances reduce the feasible policy rule weight range that achieve IOCS. Our results indicate that IOCS only applies to inflation and output stability, and that implementing IOCS targeting procedures creates volatility in interest rates.