An Evaluation of Alternative Monetary Policy Rules in a Model with Capacity Constraints

Article excerpt

Shifts in the stance of monetary policy influence the economy and financial markets with a considerable lag, as long as a year or more. The challenge of monetary policy is to interpret current data on the economy and financial markets with an eye to anticipating future inflationary forces and to countering them by taking action in advance.

Alan Greenspan (1994, p. 609)

THE MONETARY POLICYMAKER can be likened to an admiral piloting an aircraft carrier through a narrow passage in turbulent conditions. Given the long lags between changes in course and their effects on the future path of the carrier, it is important for the admiral to know as precisely as possible the effects of his actions on the current and future path of the aircraft carrier. As future sea and wind conditions, which affect this path, cannot be known with certainty, it is necessary to monitor them constantly and make appropriate adjustments in course. Keeping track of these changing conditions is obviously facilitated by relying on sophisticated radar technology and other monitoring devices.

A similar control problem exists for the monetary policymaker, but two factors make the task of steering the economy considerably more daunting. Firstly, the policymaker has a much less precise radar system, and consequently lacks some of the admiral's foreknowledge of where the "ship" is heading and of what shocks will disturb it in the near future. Secondly, the policymaker typically faces criticism, especially for policy actions that involve increases in interest rates in situations where there is no obvious evidence that inflation has risen or is about to rise.(1) The admiral faces no such problem. Although a sailor swabbing the decks may wonder why the carrier is suddenly turning, he does not question such actions and likely has come to trust the Admiral's guidance system and judgment.

It is widely accepted that there are significant lags in the monetary transmission mechanism. All recent models that purport to reflect reality contain important lags between monetary action and the subsequent effects on the economy and inflation. Monetary policymakers also widely accept the implication that their actions must be based on a forward-looking evaluation of the likely course of the economy and inflation.(2) Many central banks devote considerable resources to modeling and forecasting, and their public discussion of policy issues is increasingly cast in a forward-looking mode.(3) It also appears accepted, at least in principle, that a myopic strategy of responding only when inflation has palpably changed will delay necessary stabilization action and engender or exacerbate boom-and-bust cycles.(4) Nevertheless, the task of justifying a policy action on a forward-looking basis is difficult, as it can be done only through abstract reasoning from models and current economic indicators. Consequently, the monetary policymaker may feel constrained to wait until the evidence is difficult to dispute.(5)

One characteristic of business cycles in industrial countries in the postwar period has been that periods of deep or protracted recession have been required to reverse inflationary forces generated during periods of economic boom. Some recent empirical evidence, which is reviewed in the next section, suggests that the inflation process may be asymmetric, in that excess demand has a larger effect on inflation than an equivalent degree of excess supply. One implication of such an asymmetry is precisely that removing entrenched inflation will be relatively costly, and that early action to counteract emerging inflation pressures can reduce the need to take stronger action later. Moreover, as shown in Laxton, Meredith, and Rose (1995), for example, a prompt monetary policy response can raise the trend level of output as well as reduce the variance of output around that trend.(6)

It would not be very interesting to evaluate an overtly myopic rule where only contemporaneous inflation was considered relevant. …