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

By Peter B. Clark, Douglas Laxton, David Rose

August 1, 1995

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Peter B. Clark, Douglas Laxton, and David Rose. Capacity Constraints, Inflation and the Transmission Mechanism: Forward-Looking Versus Myopic Policy Rules, (USA: International Monetary Fund, 1995) accessed December 22, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

This paper develops a small model of the output-inflation process in the United States in order to examine the implications of alternative monetary policy rules. In particular, two types of policy rules are considered; a myopic rule where interest rates respond contemporaneously to output and inflation and a forward-looking policy rule that exploits information about the nature of transmission mechanism in the setting of interest rates. 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. As a consequence of this asymmetry, a policymaker that follows a myopic policy rule and allows the economy to overheat periodically will be forced to impose large recessions on the economy to keep inflation under control. The paper shows that the estimated degree of asymmetry implies that myopic policies can result in significant permanent losses in output. By contrast, policymakers that follow a forward-looking policy rule that avoids overheating will not only reduce the variance of output but also raise the mean level of output.

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

Publication Details

Pages:

42
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 1995/075
Stock No:

WPIEA0751995
ISBN:

9781451849677
ISSN:

1018-5941

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