poor economic performance.2 Gali', Gertler and Lopez-Salido (2003a) construct a theoretical
measure of welfare gap that is based on price and wage markups, and find that the costs of
output fluctuations for the US have been historically large and asymmetric. Erosa and Ventura
(2002) introduce transaction costs and heterogeneity in portfolio holdings in an otherwise
neo-classical model and show that these frictions can make the costs of inflation variation
asymmetric. Lastly, the psychology of choice reveals that people tend to place a greater weight
on the prospect of losses than on the prospect of gains in decision making under uncertainty
(see Kahneman and Tversky, 1979), suggesting that also policy makers, who aggregate over
individual welfare, may be loss-averse.
On the empirical side, only a few studies, developed independently, estimate an asymmetric
reaction function. Cukierman and Muscatelli (2003), and Martin and Milas (2004) show
some international evidence that supports the notion of a nonlinear interest rate rule. Ruge-
Murcia (2003), and Cukierman and Gerlach (2003) adopt an inflation rate reaction function
that is nonlinear in either inflation or the output gap, and they favor the hypothesis of an
asymmetric ob jective for some OECD economies. Dolado, Maria-Dolores and Ruge-Murcia
(2004) estimate an interest rate rule that is asymmetric in inflation only, and they find evidence
of nonlinearity after 1983 for the US.
Despite the increasing number of empirical works, no study quantifies - to our knowledge
- the average inflation bias that is associated with asymmetric preferences and no study
assesses its possible contribution to the great inflation of the 1960s and 1970s. The present
paper attempts to fill this gap. The specification of a potentially asymmetric loss function
generates the testable prediction that the monetary authorities respond non-linearly to the
deviations of inflation and the output from the target values. A main result of the paper is
that nonlinearity is a robust feature of US monetary policy rules only before 1979 and with
respect to the output gap. According to the model, these estimates imply an average inflation
bias of 1.11% during the 1960s and 1970s but a value not statistically different from zero over
the last two decades. Another main result is that a shift over sub-samples in the inflation
bias accounts for a larger fraction of the decline in the averge inflation than a reduction in the
Fed’s implicit inflation target. Hence, asymmetric preferences seem to provide an alternative
2 De Long (1997) forcefully argues that US monetary policy during the 1970s was highly sensitive to the
political pressures for a higher money growth and lower interest rates, and provides extensive narrative evidence
about the influence of Nixon’s administration on the Chairmanship of Arthur Burns at the Fed.