Monetary Policy, Inflation and Unemployment In Defense of the Federal Reserve

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, this paper estimates a New Keynesian model with unemployment and performs a counterfactual experiment where monetary policy strictly follows a Taylor rule over the period 2002:Q1 - 2006:Q4. The paper finds 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 percent would have been as high as 80 percent, while the probability of an inflation rate above 1 percent would have been close to zero.