Inflation/Output Variance Trade-Offs and Optimal Monetary Policy

Abstract

I estimate the inflation/output-gap variance trade-off faced by monetary policymakers in the U.S. For policymakers who care about deviations of inflation around target and output around potential, the estimated trade-off represents the optimal policy Given the structure of the economy, policymakers can do no better than to attain weighted variances of inflation and output that lie on the frontier. I find that the variance trade-off becomes quite severe when the standard deviation of inflation or output drops much below 2%. This suggests that approximately balanced responses to policy goals are consistent with reasonable preferences over inflation and output variability.

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