Authors Argia M. Sbordone, Andrea Tambalotti, Krishna Rao and Kieran Walsh present an introduction to policy analysis with dynamic stochastic general equilibrium (DSGE) models, analytical tools used by economists to provide a disciplined examination of the economic outlook and its interaction with monetary policy. This class of models, which emphasize the dependence of current choices on expected future outcomes, plays an important role in the formulation and communication of monetary policy by many of the world’s central banks.
Using a simple, small-scale DSGE specification, designed to account for three key macroeconomic variables—GDP growth, core inflation and the federal funds rate—the authors analyze the pickup in inflation in the United States in the first half of 2004. Their results suggest that a significant portion of the inflation acceleration in 2004 was due to a change in inflation expectations, which the model links to an increase in the private sector’s perception of the Federal Reserve’s implicit inflation target.
A key lesson derived from the study is that the most effective approach to controlling inflation is the management of inflation expectations through clear communication, rather than through pronounced movements in short-term interest rates. This lesson, according to the authors, is consistent with the amount of private sector attention and speculation that usually surround central bankers’ pronouncements on their likely future actions.
Argia M. Sbordone is an assistant vice president and Andrea Tambalotti a senior economist at the Federal Reserve Bank of New York. Krishna Rao is a graduate student at Stanford University. Kieran Walsh is a graduate student at Yale University.
Contact: David Girardin