THE LONG-RUN VARIANCE OF OUTPUT AND INFLATION UNDER ALTERNATIVE MONETARY-POLICY RULES

This study empirically estimates the trade-off between inflation and r eal growth variance faced by the Fed under the optimal and alternative policy rules using U.S. data covering the period 1959:i to 1993:ii. T he results show that, outside a narrow band, the trade-off becomes qui te steep, implying that the Fed has little room to trade-off between i ts goals. These results are consistent with those of Taylor (1979) and Fuhrer (1994). The estimates also suggest that smoothing interest rat es would produce a combination of real growth and inflation variabilit y reasonably close to an efficient outcome, and dominate the variance outcomes under money growth targets. The choice between interest rate smoothing and nominal GDP growth targets, and between nominal GDP and money growth targets, each depends on policy makers' preferences about stability in inflation versus real growth.