Forecasting and Policy Making (Paper) - Center for Financial Studies

of upward and downward risks. In the case of upward risks, raising the interest rate would become
more likely, than when the MPC’s assessment points to symmetric uncertainty or downward risks to
the inflation forecast. The adjustment of the uncertainty bands by the MPC could be useful to account
for structural changes or additional variables not taken into account by the model and past forecast
errors.
3 The role of forecasts in policy: From Tinbergen and Theil to Taylor-
style rules and optimal forecast targeting
In his formal treatment of economic policy, Tinbergen (1952) describes economic policy as the max-
imization of a collective ophelimity function by the government. This function contains a number of
variables that the policy maker wants to influence but that are not directly under her control. These
variables are called targets. Policy is implemented by manipulating variables that may be directly
controlled by the policy maker—so-called control or instrument variables. Tinbergen (1952) differ-
entiates between quantitative and qualitative policy changes. Qualitative changes imply a change in
the economic structure. Examples are the dissolution of a monopoly, the introduction of a customs
union or a monetary union. Thus, qualitative policy involves choosing from a finite number of policy
alternatives. Quantitative policy changes are defined as adjusting certain policy parameters or instru-
ments such as taxes, government expenditures or interest rates to achieve policy goals within a given
economic structure. Conveniently, Tinbergen (1952) lists the following steps for the proper conduct
of economic policy:
(i) choose a collective preference indicator;
(ii) deduce targets for economic policy from this indicator;
(iii) choose adequate instruments for achieving the targets;
(iv) determine quantitative values of the instrument variables;
(v) and formulate the connection between the targets and the instruments and the structure of the
economy.
With regard to forecasts, Theil (1958, p.3) stresses that
”A realistic analysis of the relationship between forecasts and policy must be based on
the assumption of several variables controlled and not controlled by the policy-maker, of
their interrelationships, (and) of the policy-maker’s preferences which serve to formalize
the optimality criterion” .
In the following, we focus on quantitative monetary policy in Tinbergen’s nomenclature and
present a simple framework for relating central bank objectives, decisions, models and forecasts.
12