Policy rules that are consistent with ination targeting are examined in a small macroeconometric model of the US economy. We compare the properties and outcomes of explicit instrument rules as well as targeting rules. The latter, which imply implicit instrument rules, may be closer to actual operating procedures of inflation-targeting central banks. We find that ination forecasts are central for good policy rules under inflation targeting. Some simple instrument and targeting rules do remarkably well relative to the optimal rule; others, including some that are often used as representing inflation targeting, do less well.

Numerous studies have used quarterly data to estimate monetary policy rules or reaction functions that appear to exhibit a very slow partial adjustment of the policy interest rate. The conventional wisdom asserts that this gradual adjustment reflects a policy inertia or interest rate smoothing behavior by central banks. However, such quarterly monetary policy inertia would imply a large amount of forecastable variation in interest rates at horizons of more than three months, which is contradicted by evidence from the term structure of interest rates. The illusion of monetary policy inertia evident in the estimated policy rules likely reflects the persistent shocks that central banks face.

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The present paper provides an overview of recent developments in the analysis of monetary policy in the presence of nominal rigidities. The paper emphasizes the existence of several dimensions in which the recent literature provides a new perspective on the linkages among monetary policy, inflation, and the business cycle. It is argued that the adoption of an explicitly optimizing, general equilibrium framework has not been superfluous; on the contrary, it has yielded many insights which, by their nature, could hardly have been obtained with earlier non-optimizing models.

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To be added.] # This is a revision of the text delivered by the second author as the Jacob Marschak Lecture at the 2001 Far Eastern Meeting of the Econometric Society, Kobe, Japan, July 21, 2001. We thank Julio Rotemberg and Lars Svensson for helpful discussions, and the National Science Foundation, through a grant to the NBER, for research support. Views expressed are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System.

This paper examines a shift in the dynamics of the term structure of interest rates in the U.S. during the mid-1980s. We document this shift using standard interest rate regressions and using dynamic, affine, no-arbitrage models estimated for the pre- and post-shift subsamples. The term structure shift largely appears to be the result of changes in the pricing of risk associated with a “level factor. Using a macro-finance model, we suggest a link between this shift in term structure behavior and changes in the dynamics and risk pricing of the Federal Reserve’s inflation target as perceived by investors.

We calculate optimal monetary policy rules for several variants of a simple optimizing model of the monetary transmission mechanism with sticky prices and/or wages. We show that robustly optimal rules can be represented by interest-rate feedback rules that generalize the celebrated proposal of Taylor (1993). Optimal rules, however, require that the current interest-rate operating target depend positively on the recent past level of the operating target, and its recent rate of increase, in a way that is characteristic of estimated central-bank reaction functions, but not of Taylor’s proposal. We furthermore find that a robustly optimal policy rule is almost inevitably an implicit rule, that requires the central bank to use a structural model to project the economy’s evolution under the contemplated policy action. However, calibrated examples suggest that optimal rules place less weight on projections of inflation or output many quarters in the future than do rules often discussed in the literature on inflation targeting, or in the current practice of inflation-forecast targeting central banks. This paper is excerpted from a longer working paper, circulated as “Optimal Interest Rate Rules: II.