Capacity Constraints, Inflation and the Transmission Mechanism - Forward-Looking Versus Myopic Policy Rules

WP/95/75-EA
Capacity Constraints, Inflation, and the Transmission Mechanism:
Forward-Looking Versus Myopic Policy Rules
by Peter Clark, Douglas Laxton, and David Rose

This paper explores the implications of alternative monetary policy
reaction functions using a small model of the output-inflation process in
the United States. The focus is on the extent to which the speed of the
response of the monetary authorities to actual and expected inflation can
dampen fluctuations in output. It is shown that the amplitude and length of
cycles generated by demand shocks are larger when the policymaker is myopic
and responds only to currently observed inflation than when the policymaker
is forward-looking and adjusts interest rates in the current period in light
of expected future inflation.

The model has two key features. First, there are significant lags
between interest rates and aggregate demand conditions. Second, the model
is based on an asymmetric model of inflation where positive deviations of
aggregate demand from potential are more inflationary than negative
deviations are disinflationary. This asymmetry implies that an early
monetary policy response to counteract emerging inflation pressures can
reduce the need to take stronger action later. As a consequence, a forward-
looking monetary reaction function can in fact raise the average level of
output by reducing the variance of output around the trend.

This result is derived using a simple model of the U.S. inflation
process that captures certain key features of the interactions linking
excess demand, inflation, and monetary policy. The model includes two
estimated behavioral equations, one describing a Phillips curve and the
other aggregate demand, which is specified in terms of the output gap. The
empirical work indicates that there are important asymmetries in the U.S.
output-inflation process. The model also includes a monetary policy
reaction function in which the monetary authorities are assumed to vary the
short-term interest rate to achieve their output and inflation objectives.

Both deterministic and stochastic simulations are used to derive the
implications for macroeconomic performance of forward-looking and myopic
monetary policy reaction functions. The conclusion of this analysis is that
to the extent that the monetary authorities can avert or moderate periods of
excess demand, particularly by pursuing a forward-looking approach in which
the current stance of policy takes account of expected future inflation,
they may be able to achieve significant benefits in terms of the realized
average level of output.