Policy Rules and Economic Performance
38 Pages Posted: 3 Sep 2016 Last revised: 15 Nov 2016
Date Written: October 28, 2016
Monetary policy evaluation has evolved over time from fixed rules versus discretion to policy rules versus constrained discretion. We propose a metric to evaluate monetary policy rules by calculating quadratic loss ratios, the (inflation plus unemployment) loss in high deviations periods divided by the loss in low deviations periods, with policy rules with higher loss ratios preferred to rules with lower loss ratios. The central results of the paper are (1) economic performance is better in low deviations periods than in high deviations periods for the vast majority of rules, (2) rules with larger coefficients on the inflation gap than on the output gap are preferred to rules with larger coefficients on the output gap than on the inflation gap, (3) rules with large coefficients on both gaps are preferred to rules with small coefficients on both gaps, and (4) rules with larger coefficients on the inflation gap than on the output gap and large coefficients on both gaps are strongly preferred to the opposite. This result is robust to policy lags between one and two years, different weights on inflation loss than on unemployment loss, various definitions of high and low deviations periods, time varying equilibrium real interest rates, and replacing the output gap with an unemployment gap. We conclude that the Fed should “constrain” constrained direction by following a rule with large coefficients on both gaps that responds more strongly to inflation gaps than to output gaps.
Keywords: Taylor rules, monetary rules, constrained discretion, simulations
JEL Classification: E52, E58
Suggested Citation: Suggested Citation