What Measure of Output Should be Targeted in Interest Rate Rules?∗

What measure of output, if any, should central banks target in simple interest rate rules? This paper analyzes the welfare consequences of responding to different measures of real economic activity in simple interest rate rules in a conventional New Keynesian model. Responding to the level of output is always welfare-reducing, while reacting to the level of the output gap reduces welfare if cost-push shocks are sufficiently important. In contrast, reacting to movements in the the growth rate of output improves welfare for most parameterizations and specifications of the model. Reacting to growth rates works to better anchor inflation expectations, which improves central bank tradeoffs and brings the performance of a simple interest rate rule close to that of the targeting rule implied by optimal commitment. ∗I am grateful to Yuriy Gorodnichenko, Robert Lester, and seminar participants at Notre Dame for many helpful comments which have substantially improved the paper.