Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory*

Estimating a forward-looking Federal Reserve policy rule separately for 1960-79 and 1979-96, this paper finds that the Fed let real short-term rates fall as expected inflation rose before Volcker, but raised real rates more than one-for-one with expected inflation under Volcker and Greenspan. The rule takes the Federal Funds rate target as a linear function of the gap between expected future inflation and a target, plus the expected output gap, nests Taylor’s (1993) backward-looking rule as a special case, and is estimated by GMM on quarterly U.S. data from 1960:1-1996:4. The inflation-response coefficient is estimated at 0.83 (s.e. 0.07) pre-Volcker and 2.15 (s.e. 0.40) under Volcker-Greenspan – a difference the authors show is robust to alternative inflation and output-gap measures, alternative target horizons, subsample splits by Fed chairman, and a backward-looking specification. They argue this shift, not oil shocks alone, is central to the change in macroeconomic behavior: the timing of the 1970s inflation build-up predates the first oil shock, and multivariate evidence suggests oil shocks account for only a modest share of output and inflation variation over the period. Embedding the estimated rules in a standard New Keynesian sticky-price model, the authors show that an inflation-response coefficient below one (as estimated pre-Volcker) admits self-fulfilling, sunspot-driven swings in inflation and output with no fundamental shocks at all, while a coefficient above one (as estimated post-1979) rules this out; even short of formal indeterminacy, a near-unity coefficient substantially amplifies the economy’s response to ordinary supply and demand shocks relative to a coefficient well above one. The paper explicitly leaves open why the Fed followed the inferior pre-Volcker rule for so long, offering only speculative explanations (misperceived potential output, an immature understanding of inflation dynamics).

The Science of Monetary Policy: A New Keynesian Perspective

This widely cited survey derives monetary policy design from a simple forward-looking New Keynesian model built from first principles – a forward-looking IS-type output-gap equation and a forward-looking Phillips curve – and states its conclusions as a numbered sequence of general “Results” meant to be robust across a wide variety of macroeconomic frameworks. Under discretion (no commitment), optimal policy embeds implicit inflation targeting: the central bank should adjust the nominal rate more than one-for-one with expected future inflation (Result 3, later known as the Taylor principle), should perfectly offset demand shocks but let the nominal rate stay put in the face of shocks to potential output (Result 4), and, more generally, should raise real rates whenever inflation is forecast above target and let it return only gradually. Under commitment, the paper derives a genuinely new result: even when the central bank has no temptation to push output above its natural level (ruling out the traditional Kydland-Prescott/Barro-Gordon inflationary-bias motive for commitment), a credible commitment to a rule still improves the current output-inflation trade-off, because current inflation depends on expectations of future policy, and a rational private sector will discount an un-committed promise of future toughness (Result 7). The paper also formalizes Alan Blinder’s “opportunistic” approach to disinflation as optimal when policy-makers weight small output deviations more heavily than small inflation deviations, showing it is equivalent to targeting inflation within a zone rather than at a point (Result 12), and works through practical complications including imperfect information, interest-rate smoothing, and model uncertainty. Turning from theory to practice, the paper applies its “Taylor principle” criterion to U.S. monetary history, arguing pre-Volcker policy “tended to accommodate rather than fight increases in expected inflation” while Volcker-Greenspan policy adopted the kind of implicit inflation targeting the theory recommends, and closes with simple rules (including Taylor’s and the authors’ own forward-looking variant) and open questions for future research, including endogenous inflation persistence, open-economy extensions, and the zero lower bound.

Richard Clarida | Macro Paper Warehouse

Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory*

The Science of Monetary Policy: A New Keynesian Perspective