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Monetary
Policy in an Estimated Optimization-Based Model
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Abstract This paper serves two purposes. First, it provides estimates of an optimization-based equilibrium model with sticky prices and wages. Second, the estimated model is used to analyze the welfare properties of various interest rate rules for conducting monetary policy. As shown by Erceg et al. (1999), an important feature of this model is that it involves a tradeoff between the variances of price and wage inflation and the output gap. This tradeoff implies that it is desirable for the monetary authority to respond to more than inflation, output, and past interest rates when setting the current interest rate. Indeed, the welfare optimal policy can be approximated with responses to both price and wage inflation and the past interest rate. By contrast, rules that call for a strong response to either detrended output or the output gap result in a much lower level of welfare. Jeffery D. Amato is an economist at the Bank for International Settlements. Thomas
Laubach is an economist at the Federal Reserve Bank of Kansas City. The authors gratefully
acknowledge many helpful discussions with Michael Woodford, as well as comments from Mark
Gertler, Peter Ireland, Julio Rotemberg, Argia Sbordone, and John Taylor. All remaining
errors are those of the authors. The views expressed herein are those of the authors and
do not necessarily reflect those of the Bank for International Settlements, the Federal
Reserve Bank of Kansas City, or the Federal Reserve System.
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