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- Baum, C.F. and M. Karasulu, 1998. Modelling Federal Reserve Discount Policy.

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- of this model, we consider two instruments of monetary policy--the Federal funds rate and the discount rate--which are both assumed to have effects on the financial sector, but differ in their signalling capability. We make use of well-known stylized facts about the discount rate: that it has been altered infrequently, in small increments, and almost never subjected to a reversal (e.g.
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- Baum and Karasulu, 1998).
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- These empirical regularities, coupled with the description of the discount rate by researchers inside and outside the Fed as an instrument with sizable "announcement effects," lead us to a description of policy in which a discount rate change is viewed as a credible signal of the stance of policy, precisely because such a signal is infrequently and cautiously emitted.

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- Chow, G., 1975. Analysis and Control of Dynamic Economic Systems. New York:

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- In summary, the model would appear to be reasonably well behaved, and capable of being used in an out-of-sample period to reflect the interactions of the real and financial sectors in the context of fiscal discipline and anti-inflation policy. 4 Optimal Monetary Policy Responses to Fiscal Discipline The framework in which we pose an optimal policy problem is that developed by
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- Chow (1975, 1981)
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- as an elaboration of the stochastic, dynamic linear-quadraticGaussian (LQG) optimal control framework. In a standard LQG exercise, the expectation of a multiperiod quadratic loss function is minimized, subject to the constraints posed by a linear econometric model, with stochastic elements arising from Gaussian errors.

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- Fuhrer, J. and G. Moore, 1995. Inflation Persistence. Quarterly Journal of Economics, 110:127-159.

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- The aggregate supply relation is inverted to generate the level of inflation consistent with the GDP gap and expected inflation. Inflation is modeled as a persistent phenomenon, implicitly reflecting contract terms and menu costs of price adjustment (along the lines of
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- Fuhrer and Moore, 1995).
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- Inflationary expectations are modeled with a partial adjustment scheme, in which both past expectations and recently experienced inflation affect their revision. The deviation of the discount rate from the long-term real rate of interest is used to signal the Fed's willingness to credibly reduce inflation to that level.

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- Kozicki, S. and P. Tinsley, 1996a. Moving endpoints in the term structure of interest rates. Unpublished working paper, Federal Reserve Bank of Kansas City. _____ and _____, 1996b. Moving endpoints and the Internal Consistency of Agents’ Ex Ante Forecasts. Unpublished working paper, Federal Reserve Bank of

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- be made fully credible by institutional or other changes." (1996, pp. 57-58) His rationale for that conclusion is based on the hypothesis that there are costs of disinflation, increasing more than proportionally in the rate of disinflation, related to private agents' ability to determine whether a regime change has actually taken place. (This argument is very closely related to that put forth by
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- Kozicki and Tinsley (1996a,1996b)
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- in their moving-endpoint models). King argues that "...expectations are likely to be influenced by the committment to price stability among the public at large" (1996, p. 58) and suggests that central bank behavior can only influence that commitment.

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- Orphanides, A. and D. Wilcox, 1996. The Opportunistic Approach to Disinflation.

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- The deficit-reduction and price-stability policies should be analysed in combination, as reductions in the real interest rate triggered by lower deficits will have an impact on optimal monetary policy with anti-inflation and stabilization objectives. This paper builds upon the analysis of
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- Orphanides and Wilcox (1996) to
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- evaluate optimal antiinflation policy under a broader set of circumstances than considered in their work. We consider a monetary authority with two instruments--the funds rate (or rate of base money growth) and the discount rate--with the distinction that only movements of the latter are 'credible' alterations of the Fed's policy stance, reflecting reputational effects.

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- macroeconomic performance." (1995, p.415) Thus, this strand of literature considers the importance of recognizing these dual objectives in any central bank's mandate, and taking into account the central bank's important role in promoting stability of the financial system when contemplating a single-minded macro objective. Finally, we must acknowledge the very sizable contribution of a paper by
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- Orphanides and Wilcox (1996) to
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- our development of a model of these policy issues. In their FEDS paper, they introduce the "opportunistic approach" to disinflation: the concept that the Fed may actively combat inflation only when it threatens to increase, and otherwise should wait for external circumstances (e.g. recessions) that will bring the inflation rate down.

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- Although in this framework the parameters are taken as given at their point estimates (i.e. there is no multiplicative uncertainty) the presence of additive uncertainty will generate expected loss even when "bias" is zero. The loss function applied in this problem is an extension of that used by
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- Orphanides and Wilcox (1996,
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- p.7) in their one-period model. They include three terms in their loss function a=− ̃ () 2 +y 2 +y: the squared deviation of realized inflation from an inflation target, the squared GDP gap, and the absolute value of the GDP gap.

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