Emergence of Normative Macroeconomics in the 1990s: Policy Guidelines for Central Banks

1. The New NormativeMacroeconomics John B. Taylor Stanford University XXI Encontro Brasileiro de Econometria 9 December 1999

2. Some Historical Background • Rational expectations assumption was introduced to macroeconomics nearly 30 years ago • now most common expectations assumption in macro • work on improving it ( e.g. learning) continues • The “rational expectations revolution” led to • new classical school • new Keynesian school • real business cycle school • new neoclassical synthesis • new political macroeconomic school • Now as old as the Keynesian revolution was in early 70s

3. But this raises a question • We know that many interesting schools have evolved from the rational expectations revolution, but has policy research really changed? • The answer: Yes. It took a while, but if you look you will see a whole new normative macroeconomics which has emerged in the 1990s • Interesting, challenging theory and econometrics • Already doing some good • Policy guidelines for decisions at central banks • Helping to implement inflation targeting • Constructive rather than destructive • Look at • policy models, policy rules, and policy tradeoffs

5. Characteristics of the Policy Models • Similarities • price and wage rigidities • combines forward-looking and backward-looking • frequently through staggered price or wage setting • monetary transmission mechanism through interest rates and/or exchanges rates • all viewed as “structural” by the model builders • Differences • size (3 equations to nearly 100 equations) • degree of openness • degree of formal optimization • all hybrids: some with representative agents (RBC style), other based directly on decision rules

6. Examples of Policy Models • Taylor (Ed.) Monetary Policy Rules has 9 models • Taylor multicountry model (www.stanford.edu/~johntayl) • Rotemberg-Woodford • McCallum-Nelson • But there are many many more in this class • Svensson • This conference: Hillbrecht, Madalozzo, and Portugal • Central Bank Research (not much different) • Fed: FRB/US • Bank of Canada (QPM) • Riksbank (similar to QPM) • Central Bank of Brazil (Freitas, Muinhos) • Reserve Bank of New Zealand (Hunt, Drew) • Bank of England (Batini, Haldane)

7. Solving the Models • Solution is a stochastic process for yt • In linear fi case • Blanchard-Kahn, eigenvalues, eigenvectors • In non-linear fi case • Iterative methods • Fair-Taylor • simple, user friendly (can do within Eviews), slow • Ken Judd

8. Policy Rules • Most noticeable characteristic of the new normative macroeconomics • interest in policy rules has exploded in the 1990s • Normative analysis of policy rules before RE • A.W. Phillips, W. Baumol, P. Howrey • motivated by control engineering concerns (stability) • But extra motivation from RE • need for a policy rule to specify future policy actions in order to estimate the effect of policy • Dealing constructively with the Lucas critique • time inconsistency less important

9. Interest rate Constant Real Interest Rate Policy Rule Inflation rate Target Example of a Monetary Policy Rule

10. The Timeless Method for Evaluating Monetary Policy Rules • Stick a policy rule into model fi (.) • Solve the model • Look at the properties of the stochastic steady state distribution of the variables (inflation, real output, unemployment) • Choose the rule that gives the most satisfactory performance (optimal) • a loss function derived from consumer utility might be useful • Check for robustness using other models

11. Simple model illustrating expectations effects of policy rule:(1) yt = -(rt + Etrt+1) + tPolicy Rule:(2) rt = gt + ht-1Plug in rule (2) into model (1) and find var(y) and var(r). Find policy rule parameters (g and h) to minimize var(yt) + var(rt) Observe that Etrt+1 = htIf h = 0, then by raising h and lowering g one can and get the same variance of yt and a lower variance of rt.

12. Policy Tradeoffs • Original Phillips curve was viewed as a policy tradeoff: could get lower unemployment with higher inflation • but theory (Phelps-Friedman) and data (1970s) proved that there is no permanent trade off • But there is a short run policy tradeoff • at least in models with price/wage rigidities • even in models with rational expectations • New normative macroeconomics characterizes the tradeoff in terms of the variability of inflation and unemployment

13. A simple illustration of an output-inflation variability tradeoff

14. Variance of output Variance of inflation

15. Inflation Rate AD PA target 0 Real Output (Deviation)

16. Inflation targeting • Keep inflation rate “close” to target inflation rate • In mathematical terms: minimize, over an “infinite” horizon, the expectation of the sum of the following period loss function, t = 1,2,3… w1(t - *)2 + w2 (yt – yt*)2 Or minimize this period loss function in the steady state Try to have y* equal to the “natural” rate of output

21. Historical confirmation: in the U.S. the federal funds rate has been close to monetary policy rule I Percent 12 10 8 6 0% 4 3% Federal Funds Rate 2 0 89 90 91 92 93 94 95 96 97 98

22. 12 10 Smothoed inflation rate (4 quarter average) 8 1968.1: Funds rate was 4.8% 1989.2: Funds rate was 9.7% 6 4 2 0 60 65 70 75 80 85 90

23. percent 4 2 0 -2 GDP gap with HP trend for potential GDP -4 -6 60 65 70 75 80 85 90 95

24. percent 20 Real GDP growth rate (Quarterly) 15 10 5 0 -5 -10 60 65 70 75 80 85 90 95

25. Output Stability Comparisons

26. Interest rate hitting zero problem • To estimate likelihood of hitting zero and getting stuck, put simple policy rule in policy model and see what happens: • pretty safe for inflation targets of 1 to 2 percent • Modify simple rule: • Interest rate stays near zero after the expected crises (Reifschneider and Williams (1999))

27. Interest rate Constant Real Interest Rate Policy Rule Inflation rate 0 Target

28. Inflation Rate AD PA 0 Real Output (Deviation)

29. The role of the exchange rate Extended policy rule it = gt + gyyt +ge0et + ge1et-1 + it-1 where it is the nominal interest rate, t is the inflation rate (smoothed over four quarters), yt is the deviation of real GDP from potential GDP, etis the exchange rate (higher e is an appreciation).

31. In conclusion • The “new normative macroeconomics” is currently a huge and exciting research effort • it demonstrates how policy research has changed since the rational expectations revolution • it has probably improved policy decisions already in some countries • With a great amount of macro instability still existing in the world there is still much to do.