How the Rational Expectations Revolution Has Changed - Stanford ...

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Oct 28, 2013 (3 years and 11 months ago)

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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


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 y
t


In linear f
i

case


Blanchard
-
Kahn, eigenvalues, eigenvectors


In non
-
linear f
i

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

Policy

Rule

Constant Real

Interest Rate

Interest rate

Inflation rate

Target

Example of a Monetary Policy Rule

The
Timeless Method

for
Evaluating Monetary Policy Rules


Stick a policy rule into model f
i
(.)


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)

y
t

=
-

(r
t

+ E
t
r
t+1
) +

t



Policy Rule:



(2)

r
t

= g

t

+ h

t
-
1



Plug in rule (2) into model (1) and find var(y) and var(r).
Find policy rule parameters (g and h) to minimize

var(y
t
) +

var(r
t
)



Observe that E
t
r
t+1

= h

t



If h = 0, then by raising h and lowering g

one can and get the same variance of y
t

and

a lower variance of r
t
.


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


A simple illustration of an

output
-
inflation variability tradeoff

Variance

of

output

Variance of inflation

Inflation Rate

Real Output

(Deviation)

AD

PA

0

target


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…


w
1
(

t

-


*
)
2

+ w
2
(y
t



y
t
*
)
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

0

2

4

6

8

10

12

89

90

91

92

93

94

95

96

97

98

Percent

Federal Funds Rate

0%

3%

0

2

4

6

8

10

12

60

65

70

75

80

85

90

Smothoed inflation rate

(4 quarter average)

1968.1: Funds

rate was 4.8%

1989.2: Funds

rate was 9.7%

-
6

-
4

-
2

0

2

4

60

65

70

75

80

85

90

95

percent

GDP gap with HP trend


for potential GDP

-
10

-
5

0

5

10

15

20

60

65

70

75

80

85

90

95

percent

Real GDP growth rate (Quarterly)

Output Stability Comparisons

Period


gap


growth

1959.2
-
1999.3

1.6

3.6

1959.2
-

1982.4

1.8

4.3

1982.4
-
1999.3

1.1

2.3

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))


Policy

Rule

Constant Real

Interest Rate

Interest rate

Inflation rate

0

Target

Inflation Rate

Real Output

(Deviation)

AD

PA

0

The role of the exchange rate

Extended policy rule



i
t
= g


t
+ g
y
y
t

+

g
e0
e
t
+ g
e1
e
t
-
1


+

i
t
-
1








where

i
t

is the nominal interest rate,


t

is the inflation rate (smoothed over four quarters),

y
t

is the deviation of real GDP from potential GDP,

e
t

is 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.