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There are two main approaches to modelling monetary policy; simple instrument rules and optimal policy. We propose an alternative that combines the two by extending the loss function with a term penalizing deviations from a simple rule. We analyze the properties of the modified loss function by considering three different models for the US economy. The choice of the weight on the simple rule determines the trade-off between optimality and robustness. We show that placing some weight on a simple Taylor-type rule in the loss function, one can prevent disastrous outcomes if the model is not a correct representation of the underlying economy.

We analyze the influence of the Taylor rule on US monetary policy by estimating the policy preferences of the Fed within a DSGE framework. The policy preferences are represented by a standard loss function, extended with a term that represents the degree of reluctance to letting the interest rate deviate from the Taylor rule. The empirical support for the presence of a Taylor rule term in the policy preferences is strong and robust to alternative specifications of the loss function. Analyzing the Fed's monetary policy in the period 2001-2006, we find no support for a decreased weight on the Taylor rule, contrary to what has been argued in the literature. The large deviations from the Taylor rule in this period are due to large, negative demand-side shocks, and represent optimal deviations for a given weight on the Taylor rule.

The lumpy nature of plant-level investment is generally not taken into account in the context of monetary theory (see, e.g., Christiano et al. 2005 and Woodford 2005). We formulate a generalized (S,s) pricing and investment model which is empirically more plausible along that dimension. Surprisingly, our main result shows that the presence of lumpy investment casts doubt on the ability of sticky prices to imply a quantitatively relevant monetary transmission mechanism.

This paper analyzes the effects of fiscal policy in an open economy. We extend the saversspenders theory of Mankiw (2000) to a small open economy with endogenous labor supply. We first show how the Dornbusch (1983) consumption-based real interest rate for open economies is modified when labor supply is endogenous. We then turn to the effects of fiscal policy when there are both savers and spenders. With this heterogeneity taken into account, tax cuts have a short-run contractionary effect on domestic production, and increased public spending has a short-run expansionary effect. Although consistent with recent empirical work, this result contrasts with those of most other theoretical models. Transitory changes in demand have permanent real effects in our model, and we discuss the implications for real exchange-rate dynamics. We also show how ?rational? savers may magnify or dampen the responses of ?irrational? spenders, and show how this is related to features of the utility functions.

In an influential paper Engel (1999. Accounting for U.S. Real Exchange Rate Changes, Journal of Political Economy 107, 507-538) argues that essentially all the fluctuations in the real exchange rate can be attributed to fluctuations in the relative price of traded goods, and that only a small part of the fluctuations can be attributed to changes in the relative price of non-tradables. We instead decompose the real exchange rate into three components: the relative price of traded goods at-the-dock, the difference in the relative price of non-traded to traded goods and the difference in the wedge between retail prices of traded goods and the prices of traded goods at-the-dock. Using data on US bilateral real exchange rates we find that the fluctuations in the relative wedge between retail prices and traded goods prices at-the-dock account for on average between 30 and 70 percent of the movements in the real exchange rate. These findings suggest that the relationship between traded goods prices at-the-dock and retail prices of traded goods is key to understanding real exchange rate fluctuations. ; publishedVersion

In an influential paper Engel (1999. Accounting for U.S. Real Exchange Rate Changes, Journal of Political Economy 107, 507-538) argues that essentially all the fluctuations in the real exchange rate can be attributed to fluctuations in the relative price of traded goods, and that only a small part of the fluctuations can be attributed to changes in the relative price of non-tradables. We instead decompose the real exchange rate into three components: the relative price of traded goods at-the-dock, the difference in the relative price of non-traded to traded goods and the difference in the wedge between retail prices of traded goods and the prices of traded goods at-the-dock. Using data on US bilateral real exchange rates we find that the fluctuations in the relative wedge between retail prices and traded goods prices at-the-dock account for on average between 30 and 70 percent of the movements in the real exchange rate. These findings suggest that the relationship between traded goods prices at-the-dock and retail prices of traded goods is key to understanding real exchange rate fluctuations.