Optimal Policy Projections
Lars E. O. Svensson
Stockholm School of Economics; Stockholm University - Institute for International Economic Studies (IIES); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Robert J. Tetlow
Federal Reserve Board
FEDS Working Paper No. 2005-34
We outline a method to provide advice on optimal monetary policy while taking policymakers' judgment into account. The method constructs optimal policy projections (OPPs) by extracting the judgment terms that allow a model, such as the Federal Reserve Board staff economic model, FRB/US, to reproduce a forecast, such as the Greenbook forecast. Given an intertemporal loss function that represents monetary policy objectives, OPPs are the projections - of target variables, instruments, and other variables of interest - that minimize that loss function for given judgment terms. The method is illustrated by revisiting the economy of early 1997 as seen in the Greenbook forecasts of February 1997 and November 1999. In both cases, we use the vintage of the FRB/US model that was in place at that time. These two particular forecasts were chosen, in part, because they were at the beginning and the peak, respectively, of the late 1990s boom period. As such, they differ markedly in their implied judgments of the state of the world in 1997 and our OPPs illustrate this difference. For a conventional loss function, our OPPs provide significantly better performance than Taylor-rule simulations.
Number of Pages in PDF File: 27
Keywords: Optimal monetary policy, forecasts, judgment
JEL Classification: E52, E58
Date posted: October 5, 2005
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