Monetary policy, inflation and unemployment: in defense of the Federal Reserve

Abstract

To what extent did deviations from the Taylor rule between 2002 and 2006 help to promote price stability and maximum sustainable employment? To address that question, I estimate a New Keynesian model with unemployment and perform a counterfactual experiment where monetary policy strictly follows a Taylor rule over the period 2002:Q1–2006:Q4. I find that such a policy would have generated a sizeable increase in unemployment and resulted in an undesirably low rate of inflation. Around mid-2004, when the counterfactual deviates the most from the actual series, the model indicates that the probability of an unemployment rate greater than 8% would have been as high as 80%, whereas the probability of an inflation rate above 1% would have been close to zero.