Performance Of Monetary Policy Rules Research Articles

Monetary Rules and Policy Targets Under Managed Exchange Rates and Capital Controls: The Case of China

This paper examines the performance of monetary policy rules when the economy finds itself in dark corners, when the real sector experiences a sequence of negative shocks from world demand and while the central bank faces prolonged low world interest rates on its foreign-exchange reserve holdings. We examine variations of policy rules and targets, one with strong restrictions on capital flows and a fixed exchange rate, and the other with less restricted capital flows and a more flexible managed exchange rate. Our results show that a more flexible managed exchange-rate system, based on welfare-based Ramsey rules, acts as an effective shock absorber when the economy is in a “dark corner”, thus reducing the fall in real GDP and consumption. However, this benefit comes at a cost with a much larger fall in employment and loss in foreign exchange reserves than in the more restricted fixed-rate environment. By contrast, if the Ramsey rule for monetary policy is based a on current-account or external-balance targets, employment and reserve losses are reduced. Our results suggest that external balance, rather than welfare, should be the proper target for monetary policy as the financial system moves toward a more flexible exchange rate and a less restricted capital account, at least when the economy falls into dark corner periods. These results, based on Ramsey rules, extend to the use of optimal simple rules for the interest rate and the exchange rate, with the former following a Taylor-rule specification, and the latter adjusting to current account and employment targets. However, in dark corner periods, optimal simple rules exact much higher costs, in terms of lost consumption, relative to Ramsey rules, for stabilising the current account and employment.

Monetary Regime Choice in China: Policy Rules for Navigating in Dark Corners

This paper examines the performance of monetary policy rules when the economy finds itself in dark corners. An economic dark corner can occur when the real sector experiences a sequence of negative shocks from world demand, while the central bank faces prolonged low world interest rates on its foreign reserve holdings. We examine variations of the current policy rules, based on variations of the Taylor rule with interest-rate instruments, in the context of strong restrictions on capital flows and a fixed exchange rate, and in the context of less restricted capital flows and a more flexible managed exchange rate. Our results show that a more flexible exchange-rate system with a more open capital account acts as a shock absorber when the economy is in a “dark corner”, thus reducing the fall in real GDP and consumption. However, this benefit comes at a cost. Under the more flexible exchange-rate regime with the more open capital account, during dark corner episodes, employment is much lower than in the more restricted fixed-rate environment. In the more open environment, the real exchange rate appreciates, with an increase in imported inputs, leading to a large loss of foreign exchange reserves and lower employment.

The Danger of Inflating Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping Generations Monetary Model

The volatility of inflation and output has fallen in most advanced economies in the 1990s and 2000s. We use a monetary overlapping generations model to discuss the cause and durability of this macroeconomic change. In that model, agents' decision rules require them to make forecasts of future inflation, which, because of shocks to productivity, is uncertain. Agents make forecasts of inflation using two rules of thumb or 'heuristics'. One is based on lagged inflation, the other on an inflation target announced by the central bank. They switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each. Movements in that proportion generate fluctuations in small sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilises the economy but does not prevent agents switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.

Inflation Targeting with NAIRU Uncertainty and Endogenous Policy Credibility

Stochastic simulations are employed to compare performance of monetary policy rules in linear and nonlinear variants of a small macro model with NAIRU uncertainity under different assumptions about the way inflation expectations are formed. Cases in which policy credibility is ignored or treated as exogenous are distinguished from cases in which credibility and inflation expectations respond endogenuously policy credibility strengthens the case for forward-looking inflation forecast based rules relative to backward-looking Taylor rules.

Simple Rules for Monetary Policy

How effective are monetary policy rules at stabilizing the economy? This paper explores the characteristics and performance of monetary policy rules designed to minimize fluctuations in inflation, output, and interest rates using the Federal Reserve Board's large-scale FRB/US macroeconometric model. I find that a smoothed measure of inflation, the output gap, and the lagged funds rate are sufficient statistics for the setting of monetary policy. Efficient simple rules that respond to these three variables perform nearly as well as fully optimal policies that respond to the hundreds of variables in the model, and the simple rules are more robust to model misspecification. Efficient policies smooth the interest rate response to shocks and use the feedback from anticipated policy actions to stabilize inflation and output and to moderate movements in short-term interest rates. These results hold in a wide range of macro models but are sensitive to the assumption of rational expectations.