1963 Narayana Rao Kocherlakota

This paper uses evidence from the Federal Open Market Committee’s Summary of Economic Projections to show that US monetary policymakers have objectives over unemployment and inflation outcomes that are not well approximated through a conventional quadratic loss function. Rather, policymakers derive material costs (benefits) from overshooting (undershooting) their long-run inflation and unemployment goals. The trade-off between the resultant downward tilts in unemployment and inflation played a key role in shaping the evolution of monetary policy choices since the Great Recession.

Since the collapse of the Bretton Woods monetary system, the monies of the developed world have been unbacked by any formal promise of convertibility. Yet, inflation has typically undershot, not overshot, central bank targets over the past couple decades. The low, while generally positive, inflation rate has (more arguably) been associated with low output and low growth. In this article, I consider these observations through the lens of a class of representative agent rational expectations models with nominal (price-setting) frictions and the possibility of firm entry/exit. I show that for any level of nominal frictions (no matter how small) and for any monetary policy rule that satisfies a set of weak restrictions, there is a large set of equilibria that exhibit permanently low inflation, low output, and low nominal interest rates. These equilibria can only exhibit positive long-run inflation if growth is low and the specification of nominal frictions (i.e. the Phillips curve) takes an unconventional but nonetheless empirically plausible form.

This essay discusses the structure and governance of the Federal Reserve System in light of the many changes in its activities over the past thirty years. Based on this analysis, it argues in favor of four specific reforms: clarification of Congressional expectations for the system; enhanced Federal Reserve Board of Governors transparency with respect to its oversight of the Reserve Banks; stripping monetary-policy votes from the President of the Federal Reserve Bank of New York and the Boards of Directors of the Reserve Banks; and the initiation of a public conversation about redesigning the Federal Reserve as a unified public entity. (JEL D72, E44, E52, E58, G21, G28)

In this paper, I evaluate the relative merits of rules versus discretion in making monetary policy, from both empirical and theoretical perspectives. Empirically, I argue that in the 2009–10 period, the Federal Open Market Committee aimed for a slow recovery, in large part because its judgments about appropriate monetary policy were unduly influenced by the Taylor rule (which was seen as a good approximation of its pre-2007 reaction function). Theoretically, I use the delegation framework of Bengt Holmström (1984) to show that, as long as the central bank’s inflation bias is sufficiently small, it is socially desirable to give the central bank discretion so that it can respond effectively to inflation shocks that cannot be encoded into predetermined rules.