Welfare-Based Monetary Policy Rules in an Estimated DSGE Model of the US Economy

We develop and estimate a stylized micro-founded model of the US economy. Next we compute the parameters of a simple interest rate policy rule that maximizes the unconditional mean of utility. We show that such a welfare-based rule lies close to the Taylor e¢ ciency frontier. A counterfactual analysis assesses to what extent using such a rule as a guideline for monetary policy would have helped to avoid the inationary swings of the 1970s and reduce the severity of boom and bust cycles. The paper also provides estimates of the welfare implications of business cycle variability and discusses their relevance. JEL Classi cation Numbers: C51; E31; E52 Keywords: Competition; Markups; Monetary Policy; Taylor Rule. Non-technical summary A considerable amount of research over the last decade has attempted to evaluate policy rules in empirically-based macroeconomic models with simple loss functions that penalize output, ination and interest rate variability. In practice, most of this literature has adopted analytically tractable models to construct Taylor e¢ ciency frontiers, that is, relations between variability in output and variability in ination, possibly subject to some upward bound on the degree of interest rate variability. The development of a new generation of optimizing models, as well as methods for evaluating alternative policy rules using explicit welfare criteria, have made it feasible to re-examine the results of this literature from a new perspective. Speci cally, we can now use nonlinear models to carry through formal welfare analysis that accounts for the e¤ects that variability has on the mean levels of macro variables, such as labor e¤ort, investment and real income. This paper develops a stylized micro-founded model of the US economy containing standard features such as habit persistence in consumption, adjustment costs on investment, sticky nominal wages and prices, as well as imperfect competition in both the labor and product markets. Next, we estimate the model in two steps. In the rst step, we identify the parameters that inuence the long-term relations of the model. These parameters are calibrated on the basis of previous studies, or are computed to t the observed steady-state levels of real variables. In the second step, we specify prior distributions for the parameters that inuence the business cycle and then compute the posterior distributions for each parameter using Bayesian methods. We assess the empirical validity of our model by comparing its t with the linear model that Smets and Wouters (2004) developed for the US economy, as well as other statistical representations. We then compute the parameters of a simple interest rate policy rule that maximizes the unconditional mean of utility. We show that such a welfare-based rule lies close to the Taylor e¢ ciency frontier. The paper also develops estimates of the welfare implications of excessive variability in the business cycle and shows that for the United States they are small, but signi cant enough to matter. Our nal exercise is to show what history might have looked like had this rule been used as a guideline for monetary policy. Would it have completely avoided the ination episode of the 1970s? Would it have signi cantly modi ed the macroeconomic performance of the last 20 years? To obtain a glimpse at the answers to these questions, we re-estimate the linearized version of the model starting with data from the early 1950s in order to extract historical measures of the relevant shocks. We show that such a rule lies close to the Taylor e¢ ciency frontier and that using such a rule in practice as a guideline for monetary policy would have avoided the double-digit rates of ination of the 1970s and somewhat reduced the severity of boom and bust cycles.