NAIRU Uncertainty and Nonlinear Policy Rules

Abstract

The Federal Reserve allowed unemployment to fall substantially in the late 1990s, to a level well below earlier estimates of the NAIRU, without a corresponding tightening of monetary policy. In addition, Meyer (1999) has suggested that episodes of heightened uncertainty about the NAIRU may warrant a nonlinear policy response to changes in the unemployment rate. This paper attempts to offer an explanation for the Fed's behavior and a theoretical justification for such a nonlinear policy rule, and provides some empirical evidence on the relative performance of linear and nonlinear rules when there is heightened uncertainty about the NAIRU.

Keywords: Simple nonlinear policy rule, signal extraction with non-normal prior, nonlinear updating

JEL Classification: E52, E24