Monetary Policy and Uncertainty about the Natural Unemployment Rate

Abstract

Recent empirical research concerning the relationship between ination and unemployment, a relationship that is central to the design of monetary policy, has been characterized by an active debate about the precision of relevant parameter estimates such as the estimated natural unemployment rate. This paper studies the optimal monetary policy in the presence of uncertainty about the natural rate and the short-run ination-unemployment tradeo in a simple macroeconomic model. Two conicting motives drive the optimal policy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than she would if she knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I nd that the optimal policy that balances the cautionary and activist motives typically exhibits gradualism, i.e. it is less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty i s v ery high and ination close to target.

The Usefulness of Output Gaps for Policy Analysis

“…The result is confirmed by Wieland (2003) for the euro area. ________________ 1. Earlier studies on the issue generally conclude that data uncertainty does not affect the optimal behaviour of central banks (see, for example, Estrella and Mishkin 1999).…”

“…Similar conclusions are drawn by Tetlow (2000), Rudebusch (2001) and Smets (2002) which all make use of simple macroeconomic models of the US economy to assess the impact of output gap uncertainty on optimal monetary policy. 1 Ehrmann and Smets (2003), Wieland (2003) and Gerdesmeier and Roffia (2005) investigate the impact of data uncertainty on the optimal behaviour of the European Central Bank and also conclude that policy should react more cautiously if the precise level of potential output or the NAIRU is unknown. While the first two studies use an estimated macroeconomic model of the euro area to address the issue, Gerdesmeier and Roffia (2005) Although most existing studies on the monetary policy impact of data uncertainty focus on the United States and the euro area a number of recent papers have looked at other OECD economies as well.…”

Data uncertainty and the role of money as an information variable for monetary policy

“…In contrast, indicators of aggregate quantities and prices are more difficult to construct, and are frequently subject to substantial revisions as additional information becomes available to the statistical agency. 8 For the euro area, aggregate data has only become available fairly recently (with 7 For the implications of uncertainty about output gaps and potential output (or unemployment gaps and the NAIRU) for monetary policy we refer the reader to Ehrmann and Smets (2000), Orphanides (2000) and Wieland (1998) among others.…”

Output gap uncertainty: Does it matter for the Taylor rule?

“…More recently, however, Estrella and Mishkin (1998) conclude: "Uncertainty about the level of the NAIRU has no influence on the setting of policy instruments, although it does affect the value of the objective function. This type of uncertainty makes the policymaker worse off, but does not alter the policymakers' behaviour" (see also Wieland (1997)). …”