Do Central Banks have Precautionary Demands for Expansions and for Price Stability? - A New Keynesian Approach1

This paper analyses the impact of asymmetric preferences with respect to inflation and output fluctuations on policymaker’s interest-rate reaction functions and tests for their existence. This is done by introducing non quadratic preferences into a New Keynesian framework of the type proposed in Clarida, Gali and Gertler (1999). A methodology designed to identify the dominant type of asymmetry is developed and related to the precautionary demands of policymakers for expansions and for low inflation. Using data for four G7 economies, the paper shows that, nonlinear and asymmetric behaviour is present in many cases. A main finding, for the US, is that after credibilitybuilding and disinflation have been established, the monetary authority develops a greater precautionary demand for output expansions than for low inflation. Conversely, where, as is the case in the UK during the nineties, credibility-building is still a concern for the authorities, managing the business cycle is dominated by concerns of the monetary authorities to keep inflation expectations low. JEL Codes: E58, E61