Determining output and inflation variability: are the Phillips curve and the monetary policy reaction function responsible?
The natural-rate hypothesis that no long-run trade-off exists between inflation and unemployment has won over most macroeconomists. A new trade-off between the variability of inflation and the variability of output has lately attracted considerable attention. Instead of minimizing a weighted sum of the levels of inflation and unemployment, the central bank’s objective function minimizes a weighted sum of the variances of inflation and output. Given this loss function for the central bank, a great deal of theoretical research has been undertaken as to which type of monetary policy rule is both efficient and robust. Clarida et al. (1999) and an edited volume by Taylor (1999b) investigate various monetary policy rules. In this article, I explore the determinants of inflation and output variability. First, in a theoretical study, I present the theoretical studies of Taylor (1994), Svensson (1997), and Ball (1999a) and investigate how the policy parameters in a Taylor monetary policy reacti
