A practical model-based approach to monetary policy analysis

An iterative calibration process results in which reasonable coefficient values are chosen, the properties of the model examined, and changes made to the coefficient values, or the structure of the model, until the model behaves appropriately. [...] In part this is because theory can rationalize many of the observed features of the economy but does not (yet) serve to tie down precise magnitudes.40 39Experience with use within the IMF to date suggests that, where the authorities are willing and able to discuss their own views on the properties of the economy and of their own models, the process of using the model to solicit the judgment of pol [...] For example, the model should provide reasonable estimates of: how long it takes a shock to the exchange rate to feed into the price level; the size of the sacrifice ratio— in other words, the amount of output that must be foregone to achieve a given permanent reduction in the rate of inflation, and how the inflation rate responds to the output gap. [...] The model can serve, however, to frame the discussion about the forecast, risks to the forecast, appropriate responses to a variety of shocks, and dependencies of the forecast and policy recommendations on various sorts of assumptions about the functioning of the economy. [...] For example, the analyst might consider alternative paths for the exchange rate and examine the effects of these alternative assumptions on the forecast, under the view that the link between interest rates and exchange rates is both difficult to predict and not well captured by the model.