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This paper examines the magnitude of informational problems associated with the implementation and interpretation of simple monetary policy rules. Using Taylor's rule as an example, I demonstrate that real-time policy recommendations differ considerably from those obtained with ex post revised data. Further, estimated policy reaction functions based on ex post revised data provide misleading descriptions of historical policy and obscure the behavior suggested by information available to the Federal Reserve in real time. These results indicate that reliance on the information actually available to policy makers in real time is essential for the analysis of monetary policy rules. (JEL E52, E58)
In recent years, simple policy rules have received attention as a means toward a more transparent and effective monetary policy. A series of papers have examined the performance of such rules in theoretical as well as empirical terms.' Such rules typically specify that the monetary authority set its operating instrument as a function of one or two observable variables reflecting inflationary and real activity conditions in the economy.
Often, however, the analysis underlying these policy rules is based on unrealistic assumptions about the timeliness of data availability and ignores difficulties associated with the accuracy of initial data and subsequent revisions. For example, the rule proposed by Taylor (1993) recommends setting the federal funds rate using the current-quarter output gap and inflation based on the output deflator. Taylor's rule has received considerable attention in large part because he demonstrated that the simple rule described the actual behavior of the federal funds rate rather surprisingly well. But as is well known, the actual variables required for implementation of such a rule-potential output, nominal output, and real output-are not known with any accuracy until much later. That is, the rule does not describe a policy that the Federal Reserve could have actually followed.
IV. Conclusion
Quantitative evidence suggesting that monetary policy guided by simple rules achieves good results in simulated models of the macroeconomy continues to accumulate. Thus, simple rules appear to offer useful baselines for policy discussions. The discussion, however, often does not place proper emphasis on the informational problem associated with some of the advocated policy rules. This paper examines the magnitude of this informational problem. The evidence suggests that it is substantial.
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