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The New Normative Macroeconomics. John B. Taylor Stanford University XXI Encontro Brasileiro de Econometria 9 December 1999. Some Historical Background. Rational expectations assumption was introduced to macroeconomics nearly 30 years ago

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The new normative macroeconomics

The New NormativeMacroeconomics

John B. Taylor

Stanford University

XXI Encontro

Brasileiro de

Econometria

9 December 1999


Some historical background
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


But this raises a question
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


Characteristics of the policy models
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


Examples of policy models
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)


  • Solving the models
    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


    Policy rules
    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


    Interest rate

    Constant Real

    Interest Rate

    Policy

    Rule

    Inflation rate

    Target

    Example of a Monetary Policy Rule


    The timeless method for evaluating monetary policy rules
    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


    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.


    Policy tradeoffs
    Policy Tradeoffs rule:

    • 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


    A simple illustration of an output inflation variability tradeoff
    A simple illustration of an rule:output-inflation variability tradeoff


    Variance rule:

    of

    output

    Variance of inflation


    Inflation Rate rule:

    AD

    PA

    target

    0

    Real Output

    (Deviation)


    Inflation targeting
    Inflation targeting rule:

    • 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


    Historical confirmation in the u s the federal funds rate has been close to monetary policy rule i
    Historical confirmation rule:: 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


    12 rule:

    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


    percent rule:

    4

    2

    0

    -2

    GDP gap with HP trend

    for potential GDP

    -4

    -6

    60

    65

    70

    75

    80

    85

    90

    95


    percent rule:

    20

    Real GDP growth rate (Quarterly)

    15

    10

    5

    0

    -5

    -10

    60

    65

    70

    75

    80

    85

    90

    95



    Interest rate hitting zero problem
    Interest rate hitting zero problem rule:

    • 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))


    Interest rate rule:

    Constant Real

    Interest Rate

    Policy

    Rule

    Inflation rate

    0

    Target


    Inflation Rate rule:

    AD

    PA

    0

    Real Output

    (Deviation)


    The role of the exchange rate
    The role of the exchange rate rule:

    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).


    In conclusion
    In conclusion rule:

    • 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.


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