Optimal Policy Projections

27 Pages Posted: 5 Oct 2005  

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

Multiple version iconThere are 2 versions of this paper

Date Written: August 2005

Abstract

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.

Keywords: Optimal monetary policy, forecasts, judgment

JEL Classification: E52, E58

Suggested Citation

Svensson, Lars E. O. and Tetlow, Robert J., Optimal Policy Projections (August 2005). FEDS Working Paper No. 2005-34. Available at SSRN: https://ssrn.com/abstract=813284 or http://dx.doi.org/10.2139/ssrn.813284

Lars E.O. Svensson

Stockholm School of Economics ( email )

PO Box 6501
Stockholm, 11383
Sweden

HOME PAGE: http://larseosvensson.se

Stockholm University - Institute for International Economic Studies (IIES) ( email )

Stockholm, SE-10691
Sweden

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Robert J. Tetlow (Contact Author)

Federal Reserve Board ( email )

20th and C Streets, NW
Washington, DC 20551
United States

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