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

IMF Working Papers, August 1, 1995

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

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Bibliographic details

• Authors: Peter B. Clark, Douglas Laxton, David Rose
• Published: August 1, 1995
• Series: IMF Working Papers

Model and key features

• The paper develops a small model of the output-inflation process in the United States to examine the implications of alternative monetary policy rules.
• Two types of policy rules are considered:
  • Myopic rule: interest rates respond contemporaneously to output and inflation.
  • Forward-looking rule: interest rates exploit information about the nature of the transmission mechanism.
• Two key model features:
  • Significant lags between interest rates and aggregate demand conditions.
  • An asymmetric model of inflation where positive deviations of aggregate demand from potential are more inflationary than negative deviations are disinflationary.

Main findings and analysis

• Asymmetry implication:
  • Because positive demand deviations are more inflationary than negative deviations are disinflationary, allowing periodic overheating has asymmetric costs.
• Consequences of a myopic policy rule:
  • A policymaker following a myopic rule who allows the economy to overheat periodically will be forced to impose large recessions to keep inflation under control.
  • The estimated degree of asymmetry implies that myopic policies can result in significant permanent losses in output.
• Consequences of a forward-looking policy rule:
  • Policymakers that follow a forward-looking rule and avoid overheating will reduce the variance of output.
  • Such forward-looking policies will also raise the mean level of output.

Policy implications and recommendations

• Monetary policy should account for significant lags in the transmission mechanism to avoid delayed, large contractions.
• Given the asymmetry in inflation responses to positive versus negative output gaps, policymakers should prioritize forward-looking reaction functions that prevent overheating rather than respond myopically to contemporaneous data.
• Forward-looking policy rules can achieve both lower output volatility and higher average output compared with myopic rules.

Subjects and keywords (as listed)

• Subject: Capacity utilization, Financial services, Inflation, Output gap, Potential output, Prices, Production, Real interest rates
• Keywords: aggregate demand, Capacity utilization, demand shock, Global, high-inflation period, Inflation, inflation expectation, inflation pressure, monetary policy, Output gap, output-inflation process, Phillips curve, Potential output, reaction function, Real interest rates, WP

Source: Capacity Constraints, Inflation and the Transmission Mechanism: Forward-Looking Versus Myopic Policy Rules (IMF Working Papers), authors Peter B. Clark, Douglas Laxton, David Rose, August 1, 1995.