Robust Monetary Policy Rules with Unknown Natural Rates

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Abstract
The conventional paradigm for the conduct of monetary policy calls for the monetary authority to attain its objectives of a low and stable rate of inflation and full employment by adjusting its short-term interest rate instrument—in the United States, the federal funds rate—in response to economic developments. In principle, when aggregate demand and employment fall short of the economy's natural levels of output and employment, or when other deflationary concerns appear on the horizon, the central bank should ease monetary policy by bringing real interest rates below the economy's natural rate of interest for some time. Conversely, the central bank should respond to inflationary concerns by adjusting interest rates upward so as to bring real interest rates above the [End Page 63] natural rate. In this setting, the natural rate of unemployment is the unemployment rate consistent with stable inflation; the natural rate of interest is the real interest rate consistent with unemployment being at its natural rate, and therefore with stable inflation.2 In carrying out this strategy in practice, the policymaker would ideally have accurate, quantitative, contemporaneous readings of the natural rate of interest and the natural rate of unemployment. Under those circumstances, economic stabilization policy would be relatively straightforward.

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