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The purpose of the “counter-cyclical capital buffer” (buffer) is to dampen procyclicality in the financial system, absorb capital losses and prevent a credit crunch during recessions. In this paper, a stylized analytical expression for optimal buffer policy is presented. Results are derived within a minimalist model framework, useful for a transparent presentation of how authorities’ preferences and structural parameters have implications for optimal buffer policy. In the model, there is a risk of a financial crisis, and an ex ante higher buffer may counteract the effects of it on the economy. The buffer also affects output in the short term, and here the difference between banks’ actual capital coverage ratio and capital requirements plays a role. Under quite general conditions, authorities will want to lower the buffer and allow banks to be less well capitalized today if the output gap is negative. The model illustrates that unless authorities care also about a stable bank capital coverage ratio (in addition to output stabilization and the costs of crisis), optimal policy may prescribe a very volatile buffer. In particular, that is the case if the effect of the buffer on output is weak. This result highlights the importance of learning more about the effects of buffer policy in order to achieve good policy design.

The paper provides a simple analytical framework for analyzing the interplay between monetary policy and macroprudential policy. Three questions are analyzed: (i) Under which assumptions is coordination necessary to implement an optimal policy mix? (ii) Are the two policy instruments substitutes or complements, i.e. should they move in opposite or the same direction as response to a shock? (iii) Can "leaning against the wind" in monetary policy lead to a negative inflation bias?

We analyze the influence of the Taylor rule on US monetary policy by estimating the policy preferences of the Fed within a DSGE framework. The policy preferences are represented by a standard loss function, extended with a term that represents the degree of reluctance to letting the interest rate deviate from the Taylor rule. The empirical support for the presence of a Taylor rule term in the policy preferences is strong and robust to alternative specifications of the loss function. Analyzing the Fed's monetary policy in the period 2001 - 2006, we find no support for a decreased weight on the Taylor rule, contrary to what has been argued in the literature. The large deviations from the Taylor rule in this period are due to large, negative demand-side shocks, and represent optimal deviations for a given weight on the Taylor rule.

With sticky prices, optimizing agents and money in the utility function, I derive the exact analytical solution for optimal monetary policy given a zero lower bound (ZLB) on the interest rate. The Phillips curve is Neo-Classical, and the ZLB is then not a constraint on optimal policy. Optimal policy is history dependent even without a commitment problem and implements a Friedman rule equilibrium. The role of forward guidance in policy is more limited than under a New-Keynesian Phillips curve. The optimal policy rule intercept term is time varying and depends on the variance of the natural real rate.

This paper proposes a method and a toolkit for solving optimal policy with imperfect commitment in linear quadratic models. As opposed to the existing literature, our method can be employed in medium- and large-scale models typically used in monetary policy. We apply our method to the Smets and Wouters (2007) model, where we show that imperfect commitment has relevant implications for the interest rate setting, the sources of business cycle fluctuations, and welfare.

We argue that the correct identification of monetary policy shocks in a vector autoregression requires that the identification scheme distinguishes between permanent and transitory monetary policy shocks. The permanent shocks reflect changes in the inflation target while the transitory shocks represent temporary deviations from the interest rate reaction function. Whereas both shocks may raise the nominal interest rate on impact, the inflation and output responses of the two shocks are different. We show, using a simple simulation experiment, that a failure to distinguish between the two types of shocks can result in a "price puzzle".

We use Bayesian methods to estimate the preferences of the US Federal Reserve by assuming that monetary policy is performed optimally under commitment since the mid-sixties. For this purpose, we distinguish between three subperiods, i.e. the pre-Volcker, the Volcker-Greenspan and the Greenspan period. The US economy is described by the Smets and Wouters (2007) model. We find that there has been a switch in the monetary policy regime since Volcker, with a focus on output growth instead of the output gap level as a target variable. We further show that both interest rate variability and interest rate smoothing are significant target variables, though less important than the inflation and output growth targets. We find that the "Great Moderation" of output growth is largely explained by the decrease in the volatility of the structural shocks. The Inflation Stabilization, however, is mainly due to the change in monetary policy that took place at the start of Volcker’s mandate. During the Greenspan period, the optimal Taylor rule appears to be equally robust to parameter uncertainty as the unrestricted optimal commitment rule.

We employ information-gap decision theory to derive a robust monetary policy response to Knightian parameter uncertainty. This approach provides a quantitative answer to the question: For a specified policy, how much can our models and data err or vary, without rendering the outcome of that policy unacceptable to a policymaker? For a given acceptable level of performance, the policymaker selects the policy that delivers acceptable performance under the greatest range of uncertainty. We show that such information-gap robustness is a proxy for probability of policy success. Hence, policies that are likely to succeed can be identified without knowing the probability distribution. We adopt this approach to investigate empirically the robust monetary policy response to a supply shock with an uncertain degree of persistence.

We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative properties of a monetary policy shock found in the established literature (CEE 1999). We find great interdependence between interest rate setting and stock prices. Stock prices immediately fall by 1.5 percent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock increasing stock prices by one percent leads to an increase in the interest rate of five basis points. Stock price shocks are orthogonal to the information set in the VAR model and can be interpreted as non-fundamental shocks. We attribute a major part of the surge in stock prices at the end of the 1990s to these non-fundamental shocks.

A hybrid inflation/price-level target combines elements of both inflation and price-level targets. The paper derives a hybrid target within a new Keynesian model with inflation persistence due to price indexation. The result generalizes a result by Vestin (2005) that the optimal policy could be implemented with a price-level targeting regime. We show that the optimal price-level drift in the hybrid target is equal to the degree of price indexation.

This paper discusses the optimal use of inflation forecasts in an inflation targeting setting with reaction and implementation lags. It distinguishes between the optimality of history-dependence versus forward-lookingness in monetary policymaking. It is shown that monetary policy strategy is inverted relative to private sector pricing behaviour: if private sector price setting is backward-looking, policy should be forward-looking, and vice versa.

The paper analyses alternative monetary policy regimes within a simple, estimated macroeconomic model with a traded and a non-traded sector. Two general classes of regimes are considered, inflation targeting and exchange rate targeting, where the latter also includes monetary union. By analysing monetary policy rules within a disaggregated model, the paper adds new insights to the literature on optimal monetary policy rules for open economies. The results suggest that flexible inflation targeting gives lower nominal and real variability than exchange rate targeting or monetary union. The main reason for this is that targeting the nominal exchange rate gives rise to persistent oscillations in the real interest rate and the real exchange rate due to the ’Walter’s effect’. Contrary to conventional wisdom, the results suggest that the traded sector is more stable under flexible inflation targeting than under exchange rate targeting.

This paper studies the strategic interaction between the fiscal and monetary authorities when the monetary policymaker pursues an underlying inflation target. Given that monetary policy is transparent and the fiscal policymaker can commit to a particular policy stance, the Stackelberg equilibrium can be implemented. If the conditions for Stackelberg leadership is not present, policies may end up in a Nash equilibrium, resulting in excessive interest and exchange rate volatility. Legislative restrictions on fiscal policy may then be stabilising, whereas they may be counterproductive in the Stackelberg case.

This paper examines the performance of inflation forecast feedback rules in a two-sector, calibrated model of the U.K. economy. Under such rules, the interest rate responds to the deviation of the unchanged-interest-rate forecast of inflation from the inflation target. We find that this procedure may produce a high degree of nominal and real stability, even outperforming the optimal discretionary (flexible) inflation targeting strategy. In order to take adequate account of the exchange rate channel, the feedback horizon will need to be short. A feedback horizon of a year or more creates exchange rate volatility, resulting in higher variability in inflation and traded sector output.