No 84. Should central banks be more aggressive?

Abstract

Simple models of monetary policy often imply optimal policy behavior that is considerably more aggressive than what is commonly observed. This paper argues that such counterfactual implications are due to model restrictions and a failure to account for multiplicative parameter uncertainty, rather than to policymakers being too cautious in their implementation of policy. Comparing a restricted and an unrestricted version of the same empirical model, the unrestricted version leads to less volatility in optimal policy, and, taking parameter uncertainty into account, to policy paths very close to actual Federal Reserve policy.