Monetary Policy and Uncertainty about the Natural Unemployment Rate

Volker Wieland - Federal Reserve Board

There has been a renewed surge of interest in estimating the parameters of the Phillips curve and in particular the natural unemployment rate (NAIRU). Recent research in this literature emphasizes that estimates of the slope of the inflation-unemployment relation and the NAIRU are fairly imprecise and that the NAIRU may have changed over time. This paper investigates the implications of such uncertainty for a monetary policy strategy that is based on the concept of a NAIRU. It computes the optimal policy in the presence of uncertainty about the natural rate and the short-run inflation-unemployment tradeoff in a simple macroeconomic model. In the static version of the model uncertainty provides a motive for the policymaker to move more cautiously than she would if she knew the true parameters. In the dynamic version, uncertainty motivates an element of experimentation in policy. The optimal policy that balances the cautionary and activist motives derived from Phillips curve uncertainty still exhibits gradualism.

Scheduled for Session 1.3 Optimum Policy Making Under Uncertainity