Monetary Policy, Inflation and Unemployment in Defense of the Federal Reserve
Centre for Applied Macroeconomics Analysis Working Paper No. 37/2010
56 Pages Posted: 24 Dec 2010
Date Written: December 24, 2010
To what extent did deviations from the Taylor rule between 2002 and 2006 help to promote price stability and maximum sustainable employment? To address that question, this paper estimates a New Keynesian model with unemployment and performs a counterfactual experiment where monetary policy strictly follows a Taylor rule over the period 2002:Q1 - 2006:Q4. The paper finds that such a policy would have generated a sizable increase in unemployment and resulted in an undesirably low rate of inflation. Around mid-2004, when the counterfactual deviates the most from the actual series, the model indicates that the probability of an unemployment rate greater than 8 percent would have been as high as 80 percent, while the probability of an inflation rate above 1 percent would have been close to zero.
Keywords: DSGE Models, Inflation, Unemployment, Taylor Rules
JEL Classification: E32, C51, C52
Suggested Citation: Suggested Citation