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### The New NormativeMacroeconomics

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
- 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

- 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

- 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

- 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

- 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

- 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

Constant Real

Interest Rate

Policy

Rule

Inflation rate

Target

Example of a Monetary Policy Rule

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 = gt + ht-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 = htIf 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

- 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

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

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

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

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))

The role of the exchange rate

Extended policy rule

it = gt + 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

- 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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