Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory

We estimate a forward-looking monetary policy reaction function for the US economy, pre- and post-October 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected inflation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of inflation and output, using a simple macroeconomic model. The pre-Volcker rule is shown to be consistent with the possibility of persistent, self-fulfilling fluctuations in inflation and output.