explanation for the US great inflation.
The road map of the paper is as follows. Section 2 presents the model and derives the
interest rate rule as the first order condition of the central bank optimization problem. Section
3 reports the estimates of both the policy rule coefficients and the preference parameters, and
conducts a robustness analysis. The following section shows that asymmetric preferences on
the output gap induce an average inflation bias, and proposes a simple strategy to decompose
the actual inflation mean into a target and a bias argument. Section 5 concludes.
2 Theoretical model
Following Svensson (1999), the policy rule is modeled as the outcome of an intertemporal
optimization problem in which the decision makers minimize a given criterion sub ject to the
constraints provided by the structure of the economy. The optimizing device allows us to
back out the objectives of the monetary authorities, which are unobserved, from the observed
path of policy rates implying that evidence on the latter can be interpreted as informative
about the former. Since our identification strategy relies on the estimation of a model-based
specification for the reaction function, we challenge the assumption of symmetric preferences
in the context of a popular framework for monetary policy analysis. This is a version of the
New-Keynesian model of the business cycle derived in Yun (1996), and Woodford (2003, chs.
3 and 4), among many others.3
2.1 The structure of the economy
This subsection describes an aggregate, log-linearized version of the New-Keynesian forward-
looking model with sticky prices that has been recently summarized by Clarida, Gali' and
Gertler (1999). The evolution of the economy is represented by the following two-equation
system:
πt = θEtπt+1 + kyt + εts (1)
yt = Etyt+1 — ψ (it — Et∏t+1) + εd (2)
Equation (1) captures the staggered feature of a Calvo-type world in which each firm
adjusts its price with a constant probability in any given period, and independently from the
3 Surico (2003) shows that both the theoretical and the empirical results obtained here using a New-Kynesian
model are robust to the specification of a Lucas aggregate supply curve as the structure of the economy.