Working Paper: CEPR ID: DP5072
Authors: Lars E. O. Svensson
Abstract: ?Forecast targeting?, forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the US economy, one forward looking and one backward looking. A complicated infinite-horizon central bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank?s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.
Keywords: forecasts; inflation targeting; optimal monetary policy
JEL Codes: E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank judgment (E58) | monetary policy performance (E52) |
| judgmental forecasting (C53) | effectiveness of monetary policy (E52) |
| disregarding judgment (K40) | complex reaction function (D79) |
| central bank judgment (E58) | improved outcomes (I14) |