Imperfect Knowledge and Monetary Policy Based on lectures given as part of The Stone Lectures in Economics, this book discusses the problem of formulating monetary policy in practice, under the uncertain circumstances which characterize the real world. The first lecture highlights the limitations of decision rules suggested by the academic literature and recommends an approach involving, first, a firm reliance on the few fundamental and robust results of monetary economics and, secondly, a pragmatic attitude to policy implementation, taking into consideration lessons from central banking experience. The second lecture revisits Milton Friedman s questions about the effects of active stabilization policies on business cycle fluctuations. It explores the implications of a simple model where the policy maker has imperfect knowledge about potential output and the private sector forms expectations according to adaptive learning. This lecture shows that imperfect knowledge limits the scope for active stabilization policy and strengthens the case for conservatism. otmar issing isamemberoftheexecutiveboard,european Central Bank. vítor gaspar is Special Advisor, Banco de Portugal. oreste tristani is Principal Economist, DG Research, European Central Bank. david vestin is Economist, DG Research, European Central Bank. www.cambridge.org
The Stone Lectures in Economics Already published: Statistics, Econometrics and Forecasting Arnold Zellner www.cambridge.org
Sir Richard Stone, Nobel Laureate in Economics. www.cambridge.org
the stone lectures in economics Imperfect Knowledge and Monetary Policy Otmar Issing and Vítor Gaspar with Oreste Tristani and David Vestin www.cambridge.org
cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo The Edinburgh Building, Cambridge CB2 2RU, UK Published in the United States of America by, New York www.cambridge.org Information on this title: www.cambridge.org/9780521671071 C Otmar Issing, Vítor Gaspar, Oreste Tristani and David Vestin 2005 This book is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of. First published 2005 Printed in the United Kingdom at the University Press, Cambridge A catalogue record for this book is available from the British Library ISBN-13 978-0-521-85486-3 hardback ISBN-10 0-521-85486-5 hardback ISBN-13 978-0-521-67107-1 paperback ISBN-10 0-521-67107-8 paperback has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this book, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. www.cambridge.org
Contents List of figures and table Acknowledgments page ix xi Introduction 1 Outline of the two lectures 7 Lecture 1: Monetary policy in uncharted territory 12 1.1 Introduction 12 1.2 Uncharted territory: unique historical events 15 1.3 Achieving price stability 23 1.4 Avoiding excess volatility in inflation, output, and the interest rate 38 1.5 Pragmatic monetarism: the Bundesbank 47 1.6 A stability-oriented strategy: the ECB 61 1.7 Conclusions 74 Lecture 2: Imperfect knowledge, learning, and conservatism 77 2.1 Introduction 77 2.2 Time inconsistency, cost-push shocks and Rogoff s conservatism 83 2.3 Empirical output gap uncertainty 96 2.4 Output gap uncertainty, learning, and conservatism 100 vii www.cambridge.org
viii Contents 2.5 Different degrees of central bank knowledge and information 108 2.6 Conclusions 114 Notes 117 References 122 Index 136 www.cambridge.org
Figures and table Figures 1.1 CPI Inflation, 1961 2001 page 48 1.2 Longer-term averages for German M3 and CPI developments, 1971 98 53 1.3 M3 in Germany, 1988 98 56 1.4 Annual rate of growth of M3 in Germany, 1988 98 58 1.5 M3 money growth and HICP inflation in the euro area, 1994 2004 72 1.6 Longer-term inflation expectations, 1999 2004 73 2.1 Informational assumptions 87 2.2 Rational expectations, observable shocks 90 2.3 Loss: rational expectations with observable shocks 91 2.4 Private sector learning; central bank has perfect information 94 2.5 Loss: private sector learning 95 2.6 Real-time and two-sided estimates for the HP filter, and different UC models, for the euro area, 1980 2000 97 2.7 Empirical properties of different estimates, euro area data, 1980 2000 99 ix www.cambridge.org
x List of figures and table 2.8 Central bank: imperfect information, private sector with fixed RLS coefficients 102 2.9 Loss: imperfect information, no private sector learning 103 2.10 Constant gain: learning and imperfect information 105 2.11 Losses with output gap uncertainty and private sector learning 106 2.12 From perfect to imperfect information 110 2.13 Loss functions: from perfect to imperfect information 111 Table 1.1 Monetary targets and their implementation 51 www.cambridge.org
Acknowledgments We wish to thank Klaus Adam, Steve Cecchetti, Athanasios Orphanides, Gerhard Rünstler, Frank Smets, and Caroline Willeke for helpful comments and suggestions on a preliminary draft. Sandrine Corvoisier and Björn Fischer provided excellent research assistance. We also wish to thank Patricia Kearns-Endres and Luisa Rey for editorial assistance and the organizers of the Stone Lectures Series at the Bank of England and at the National Institute for Economic and Social Research for their help. A final thank you to Chris Harrison for ensuring a smooth and pleasant interaction between the authors and the publisher. xi www.cambridge.org