The Role of Output Stabilization in the Conduct of Monetary Policy
25 Pages Posted: 19 Oct 2002
Date Written: October 2002
This paper examines the role of output stabilization in the conduct of monetary policy. It argues that activist monetary policy in which the monetary authorities focus on output fluctuations in the setting of their policy instrument and in policy statements is likely to produce worse outcomes for output and inflation fluctuations, both because it will lead to suboptimal monetary policy, but also because it complicates monetary authorities' communication strategy and can weaken the credibility of the central bank. In contrast, conducting monetary policy with a flexible inflation target rule is likely to produce better outcomes. A flexible inflation target rule also allows the monetary authorities to effectively communicate to the public that they do care about output fluctuations, but makes it less likely that they will be encouraged to try to exploit the short-run tradeoff between output and inflation.
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