This paper reviews the recent literature on monetary policy rules. To organize the discussion, we exposit the monetary policy design problem within a simple baseline theoretical framework. We then consider the implications of adding various real word complications. We concentrate on developing results that are robust across a reasonable variety of competing macroeconomic frameworks. Among other things, we show that the optimal policy implicitly incorporates inflation targeting. We also characterize the gains from making credible commitments to fight inflation and consider the implications of frictions such as imperfect information and model uncertainty. Finally, we assess how proposed simple rules, such as the Taylor rule, square with the principles for optimal policy that we describe. We use this same metric to evaluate the recent course of U.S. monetary policy.

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The Science of Monetary Policy: A New Keynesian Perspective

We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker’s appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected ineation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of ineation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing.

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Monetary policy rules and macroeconomic stability: Evidence and some theory

Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

Monetary Theory and Policy

Since the seminal work of Krugman (1979), product variety has played a central role in models of trade and growth. In spite of the general use of love-of-variety models, there has been no systematic study of how the import of new varieties has contributed to national welfare gains in the United States. In this paper we show that the unmeasured growth in product variety from US imports has been an important source of gains from trade over the last three decades (1972-2001). Using extremely disaggregated data, we show that the number of imported product varieties has increased by a factor of four. We also estimate the elasticities of substitution for each available category at the same level of aggregation, and describe their behavior across time and SITC-5 industries. Using these estimates we develop an exact price index and find that the upward bias in the conventional import price index is approximately 1.2 percent per year – double the estimated impact due to hedonic adjustments on the CPI. The magnitude of this bias suggests that the welfare gains from variety growth in imports alone are 2.8 percent of GDP per year.

/pdf/globalization-and-the-gains-from-variety-3t7kyqz9ei.pdf

Globalization and the gains from variety

Since the seminal work of Krugman (1979), product variety has played a central role in models of trade and growth. In spite of the general use of love-of-variety models, there has been no systematic study of how the import of new varieties has contributed to national welfare gains in the United States. In this paper we show that the unmeasured growth in product variety from US imports has been an important source of gains from trade over the last three decades (1972-2001). Using extremely disaggregated data, we show that the number of imported product varieties has increased by a factor of four. We also estimate the elasticities of substitution for each available category at the same level of aggregation, and describe their behavior across time and SITC-5 industries. Using these estimates we develop an exact price index and find that the upward bias in the conventional import price index is approximately 1.2 percent per year. The magnitude of this bias suggests that the welfare gains from variety growth in imports alone are 2.8 percent of GDP.

/pdf/globalization-and-the-gains-from-variety-1xq8uo2x2z.pdf

Globalization and the Gains from Variety

For over ten years, the Treasury has issued index-linked debt. This paper describes the methodology for fitting a smoothed yield curve to these securities that is used at the Federal Reserve Board every day, and makes the estimates public. Comparison with the corre sponding nominal yield curve allows measures of inflation com pensation to be computed. We discuss the interpretation of inflation compensation, and provide evidence that it is not a pure measure of inflation expectations being distorted by inflation risk premium and liquidity premium components. We attempt to estimate the TIPS liquidity premium and to extract underlying inflation expectations.

/pdf/the-tips-yield-curve-and-inflation-compensation-1q760x4ka6.pdf

The TIPS Yield Curve and Inflation Compensation

* Treasury inflation-indexed securities (TIIS) have yet to live up to one of their primary goals: reducing the U.S. Treasury's expected financing costs. * Since 1997, yields on TIIS have been surprisingly high relative to yields on comparable nominal Treasury securities, with the spread between yields falling, on average, well below survey measures of long-run inflation expectations. * This study attributes this "valuation puzzle" to several factors: investor difficulty adjusting to a new asset class, divergent supply trends between TIIS and nominal Treasuries, and the lower liquidity of TIIS. In addition, investors may have had a benign outlook for inflation and inflation risks. * More recently, the liquidity and breadth of investor participation in the TIIS market have increased notably, and the valuation of these securities appears to have improved. l. INTRODUCTION In January 1997, the U.S. Treasury began issuing Treasury inflation-indexed securities (TIIS)--debt securities with coupon and principal payments that adjust in line with a measure of consumer prices. Through 2003, the Treasury had issued $172 billion of these securities, with maturity dates ranging from 2002 to 2032. By the end of 2003, the amount of TIIS outstanding (including inflation accrual) totaled approximately $176 billion, or nearly 7 percent of all outstanding Treasury notes and bonds. Inflation-indexed debt held the promise of providing benefits to both investors and the Treasury. Investors could benefit, it was argued, from access to a new type of asset that reduces the risks associated with inflation. By purchasing inflation-indexed securities, they could lock in a real rate of return--measured in terms of the amounts of goods and services that can be purchased--over the maturity of the security, thereby protecting themselves against the possibility that an unexpected rise in inflation would erode the real return on a nominal debt security. (1) Moreover, the Treasury's willingness to issue TIIS could provide a benchmark that would spur private issuance of inflation-indexed securities. The Treasury would also benefit, some argued, because the issuance of inflation-indexed debt would likely reduce its financing costs. The rationale was that investors typically demand a higher return on nominal debt securities to compensate for the risks associated with future inflation. By issuing inflation-indexed debt, the Treasury would eliminate that risk for investors and therefore avoid having to pay this "inflation risk premium," which would also lower its financing costs. (2) In addition, some argued that issuing indexed debt would offer ancillary benefits by providing policymakers and market participants with a useful reading of real interest rates. In that case, comparing the yields on TIIS with those on nominal securities would provide a measure of the amount of compensation that investors demand to offset future inflation and the associated risks--a potentially useful gauge for monetary policymakers. This article describes the U.S. experience with inflation-indexed debt, including the evolution of activity in the TIIS market since its inception and the valuation of those securities relative to nominal Treasury issues. We show that despite the potential appeal of TIIS, their yields have been surprisingly high relative to those on comparable nominal Treasury securities. Indeed, the spread between ten-year yields on nominal securities and TIIS has, on average, fallen about 50 basis points below the long-run inflation expectations reported in the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia. We analyze several explanations for this "valuation puzzle" as well as offer evidence that bears on those explanations. One possibility is that the low relative valuation of TIIS has reflected investor difficulty adjusting to a new asset class. …

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Treasury Inflation-Indexed Debt: A Review of the U.S. Experience

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is in contrast to the prediction of many macroeconomic models, in which the long-run properties of the economy are assumed to be time-invariant and perfectly known by all economic agents: Under those assumptions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. We present an alternative model that captures this behavior. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have demonstrated little excess sensitivity since the Bank of England achieved independence in mid-1997.

The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models

Linearized New Keynesian models and empirical no-arbitrage macro-finance models offer little insight regarding the implications of changes in bond term premiums for economic activity. We investigate these implications using both a structural model and a reduced-form framework. We show that there is no structural relationship running from the term premium to economic activity, but a reduced-form empirical analysis does suggest that a decline in the term premium has typically been associated with stimulus to real economic activity, which contradicts earlier results in the literature.

Macroeconomic implications of changes in the term premium

Many researchers have found that the lagged interest rate enters estimated monetary policy rules with overwhelming significance. However, a recent paper by Rudebusch (2002) argues that the lagged interest rate is not a fundamental component of the U.S. policy rule, and that its significance arises from the omission of serially correlated variables from the policy rule. This paper demonstrates that, contrary to Rudebusch's claims, these two hypotheses can be directly distinguished in the estimation of the policy rule. Our findings indicate that while serially correlated omitted variables may be present, the lagged interest rate enters the policy rule on its own right and plays an important role in describing the behavior of the federal funds rate.

Brian P. Sack

Papers

The TIPS Yield Curve and Inflation Compensation

Treasury Inflation-Indexed Debt: A Review of the U.S. Experience

The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models

Macroeconomic implications of changes in the term premium

Interpreting the significance of lagged interest rate in estimated monetary policy rules