Econometric Policy Evaluation and Inverse Control

Abstract

The traditional approach to monetary policy evaluation entails a first step in which structural parameters are estimated and a second in which the performance of alternative policy rules is studied. This paper combines the two steps of the traditional approach into one by estimating a structural model subject to the restriction that the central bank chooses the policy rule that minimizes expected loss. The structure is a forward-looking New Keynesian model in which equilibrium values of output and inflation depend on expectations of future values of those variables. Analysis of U.S. data between 1965 and 2001 support the hypotheses that the sample contains two policy regimes, that the Fed placed far greater weight on stabilizing inflation after 1980, and that improvements in policy were available in both regimes. The unified approach also sharpens estimates of structural parameters.