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

Abstract

A small model of the U.S. output-inflation nexus is used to examine the implications of two policy rules, one where the interest rate responds to contemporaneous inflation and one where the response is a forecast of future inflation. The model is asymmetric in that positive deviations of aggregate demand from potential are more inflationary than negative deviations are disinflationary. With asymmetry, following a myopic rule and allowing the economy to overheat requires deep or protracted recessions to control inflation, whereas following a forward-looking rule not only reduces volatility but also raises the equilibrium level of output. 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)

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