Optimal Interest-Rate Rules

To be added.] ∗This is a revision of the text delivered by the second author as the Jacob Marschak Lecture at the 2001 Far Eastern Meeting of the Econometric Society, Kobe, Japan, July 21, 2001. We thank Julio Rotemberg and Lars Svensson for helpful discussions, and the National Science Foundation, through a grant to the NBER, for research support. Views expressed are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System. Both positive and normative accounts of monetary policy are often expressed in terms of systematic rules for determining the central bank’s operating target for a short-term nominal interest rate. For example, the “Taylor rule” (Taylor, 1993) expresses the Fed’s operating target for the federal funds rate as a linear function of a current inflation rate and a current measure of output relative to potential. Econometrically estimated central-bank reaction functions are often similar in form, though generally more complex (e.g., Judd and Rudebusch, 1998; Clarida et al., 2000). Alternatively, both positive and normative accounts of “inflation targeting” typically describe such a regime as a commitment to adjust a nominal interest-rate instrument as necessary in order to bring about an inflation projection (say, over a two-year horizon) consistent with the central bank’s inflation target (e.g., Vickers, 1998; Svensson, 1999). Here we are concerned with the question of how economic theory can be used in the design of a desirable policy rule of one of these kinds. Some of the questions we wish to address include: When is it desirable for a monetary policy to be determined by a rule for setting a short-term nominal interest rate as a function of actual or projected inflation and output-gap measures, as proposed by Taylor? How do quantitative aspects of one’s model of the monetary transmission mechanism, and of the specification of one’s stabilization goals, determine the strength of the desirable feedback from variations in current and/or projected economic conditions and the appropriate interest-rate operating target? To what extent is it desirable for a policy rule to incorporate the sort of inertial adjustment of interest rates typically characteristic of estimated reaction functions? To what extent is it desirable for policy to depend upon forecasts of future conditions, and if so, at what future horizons? Questions of the kind just posed have been the topic of an extensive recent literature. However, the existing literature typically considers them by assuming a low-dimensional parametric family of policy rules, and then optimizing over the parameters of the rule, using some economic model to compute the equilibrium associated with each possible set of parameters. A characteristic weakness of such work, in our view, is that the conclusions See, e.g., the papers in Taylor (1999).