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May/June 2008, Part 2, 
Vol. 90, No. 32
Posted 2008-06-01

Inertial Taylor Rules: The Benefit of Signaling Future Policy

by Charles T. Carlstrom and Timothy S. Fuerst

This article traces the consequences of an energy shock on the economy under two different monetary policy rules: (i) a standard Taylor rule, where the Fed responds to inflation and the output gap, and (ii) a Taylor rule with inertia, where the Fed moves slowly to the rate predicted by the standard rule. The authors show that, with both sticky wages and sticky prices, the outcome of an inertial Taylor rule is superior to that of the standard rule, in the sense that inflation is lower and output is higher following an adverse energy shock. However, if prices alone are sticky, the results are less clear and the standard rule delivers substantially less inflation than the inertial rule in the short run.