Generally, the ultimate objectives of monetary policy are low and stable inflation and maximum sustainable economic growth. Central banks have increasingly sought to achieve these goals through the formulation of formal inflation targets. In pursuing such a target, most central banks use an overnight interest rate as the instrument of policy, but exactly how the instrument should be moved to achieve the objectives of policy is an issue of active debate. A number of simple interest-rate feedback rules have been proposed to assist in setting the overnight interest rate. The aim of this paper is to analyse these rules in a simple but data-consistent framework of the Australian economy. We do this by trying to answer a number of questions. What sort of simple policy rule – for example, an inflation-only rule, Taylor rule or nominal-income rule – performs best? Given that the economy is subject to a variety of shocks, how much can policy stabilise the economy, and how steep is the trade-off between the variability of inflation and output? How do policy rules vary with changes in inflation expectations induced by the inflation target itself? Do simple rules which also let policy respond to other variables perform better than simple rules based on inflation and output alone? Finally, should policy rules be based on actual or expected values of the target variables? The structure of the paper follows these questions. Section 2 reviews some terminology about feedback rules, and presents a simple empirical framework of the Australian economy which is used for analysis. Section 3 evaluates several interest-rate rules, and explores the properties of what appears to be the most efficient of these, the Taylor rule. Section 4 addresses how greater credibility can affect price-setting behaviour, and what this may mean for the economy and monetary policy. Section 5 examines whether information in addition to inflation and output improves the rule. Section 6 examines whether forward-looking, rather than backward-looking, rules more successfully stabilize the economy. The findings of the paper are summarised in Section 7.
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