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Regulation and the neo-Wicksellian approach to monetary policy.

Article Excerpt
THE NEO-WICKSELLIAN approach to optimal monetary policy uses estimates of the neutral real interest rate, often in a Taylor rule. In a system with investment saving (IS) and output-gap inflation equations, Laubach and Williams (2003) use a Kalman filter approach to jointly estimate the neutral real federal funds rate and trend output growth. They find a positive link between these two variables, which Trehan and Wu (2007) show reduces the potential for policy to be misled by errors in tracking trend output. Laubach and Williams note that there is much error and uncertainty surrounding estimates of the neutral real rate, as Clark and Kozicki (2005) also find. Although their estimation assumptions allow their approach to track the impact of drawn-out structural changes on the neutral real rate, they may not control for institutional factors that may have large, but temporary effects. But addressing such factors entails complicating a Laubach-Williams specification, which runs the risk that coefficient estimates may not converge to sensible values. Hence, a tension between greater precision and the need for parsimony arises. We modify the Laubach-Williams (LW) model in a computationally tractable way by altering their IS relationship to reflect the extra, disintermediation channel through which nominal interest rates at times made regulatory ceilings on deposits binding and find that the effective federal funds rate was higher in these episodes. We use Duca's (1996) measure of how binding Regulation Q (Reg Q) deposit ceilings were, which is statistically and economically significant in traditional models of residential construction (Duca 1996) and gross domestic product (GDP) (Duca 1998), as well as in a more modern dynamic stochastic general equilibrium (DSGE) framework (Mertens 2006). When these ceilings were binding, monetary policy induced disintermediation that curtailed lending in an era before the mortgage-backed securities market became deep. Thus, when Reg Q was binding, monetary policy had a more restrictive overall effect, which if unaccounted for, leads to omitted variable bias and parameter instability in samples spanning the deposit regulation era and the post-1982 deregulated era.

We also modify the inflation equation to include Gordon's (1977) variables for the imposition and lifting of the Nixon wage-price controls. Given the small number of business cycles in the post-Korean War era, omitting an important factor affecting prices could affect inflation coefficients. Indeed, including these variables results in a much larger estimated effect of the output gap on inflation. Furthermore, the inclusion of both price and deposit regulation variables has notable effects on key economic coefficients, which have important implications for how policy should respond to deviations of inflation and output from desired levels.

1. ESTIMATING THE NATURAL RATE AND KEY PARAMETERS

As in Lauhach and Williams (2003), we use the Kalman filter to...

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