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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
slide9

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
slide11

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
  • 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
slide14

Variance

of

output

Variance of inflation

slide15

Inflation Rate

AD

PA

target

0

Real Output

(Deviation)

inflation targeting
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
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

slide22

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

slide23

percent

4

2

0

-2

GDP gap with HP trend

for potential GDP

-4

-6

60

65

70

75

80

85

90

95

slide24

percent

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
  • 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))
slide27

Interest rate

Constant Real

Interest Rate

Policy

Rule

Inflation rate

0

Target

slide28

Inflation Rate

AD

PA

0

Real Output

(Deviation)

the role of the exchange rate
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).

in conclusion
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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