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.
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