. 3. policy rules to inform discretionary monetary policy a third contribution of models to the monetary policy process is through simulations with alternative rules for federal reserve action. at lhm & a we designed our model to offer users four policy regimes : setting paths for the money supply, nonborrowed reserves or the federal funds rate or turning on a reaction function according to which the federal funds rate responds to developments in output, unemployment and inflation. while we increasingly used the reaction function in our analysis of alternative fiscal policies, we did not routinely take advantage of the reaction function to forecast monetary policy. another irony is that there is a much more active interest in the implications of monetary policy rules at the board, where discretionary policy is made, than in the private sector, where estimated rules might be effectively used to forecast monetary policy. the staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, taylor - type rules. these rules, in effect, adjust the real federal funds rate relative to some long - run equilibrium level in response to the gaps between actual and potential output and between inflation and some long - run inflation target. such a rule can be interpreted as either a descriptive or normative guide to policy. if the parameters of the policy rule are estimated over some recent sample period, the rule may describe the average response of the fomc over the period. alternatively, parameters can be derived from some optimizing framework, dependent on a specific objective function and model of the economy. stochastic simulations with such a rule can provide some confidence that following the rule will contribute to both short - run stabilization and long - term inflation goals in response to historical shocks to the economy and the rule, in turn, can provide discipline to discretionary policy by providing guidance on when and how aggressively to move interest rates in response to movements in output and inflation. the focus on rules is much more important under an interest rate operating procedure than under an operating procedure focused directly on monetary aggregate targets and is also more important under an interest rate operating procedure when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. taylor - type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro - cyclical response of interest

, the model is much more flexible in terms of research potential. it allows one to study in particular how the response to monetary or fiscal policies depends on features of the expectation formation process. third, the model forces the user to make assumptions explicitly about expectations formation that otherwise could be avoided or hidden. let me give two examples of policy options that can be analyzed more effectively in the new model. first, consider a deficit reduction package that is credible and promises to lower interest rates in the future. in models like mps and wumm, the mechanical fiscal policy simulation would ignore any “ bond market effect ” associated with changed expectations about future short - term rates. one could, of course, add - factor downward the long - term bond rate in the term structure equation to impose a bond market effect, but the structure of the model neither immediately points you in this direction nor provides any guidance about how to intervene. in frb - us, in contrast, one cannot avoid making an explicit assumption about the credibility of such a policy ( through assumptions about future short - term interest rates in the var expectations or in the context of model - consistent expectations ) and the assumption made about credibility will importantly affect the short - run dynamics though not the long - run effects of the policy. second, consider the transitional costs of reducing inflation. the transitional effects on output depend importantly on the assumptions made about the credibility of the inflation commitment. note, however, that there are significant transitional output costs of disinflation even under full credibility and the model - consistent specification of rational expectations, arising from the sticky price implication of the adjustment cost specification. for my part, i prefer the frb - us simulations based on limited rather than perfect credibility, because i do not believe that credibility effects significantly diminish the transition costs of lowering inflation. but i also value having a disciplined approach to showing how the costs of disinflation would vary with the differing degrees of credibility. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ references brayton, f., a. levin, r. tryon, and j. williams. “ the evolution of macro models at the federal reserve board. ” mimeo. board of governors of the federal reserve system, november 1996. brayton, f. and p. tinsley. “ a guide to frb / us : a macroeconometric model of the united states. ” feds 96 - 42, 1996. reifsch