Recent Developments in the Analysis of Monetary Policy Rules

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It is a great privilege for me to be giving this year's Homer Jones Memorial Lecture, in recognition of Homer Jones's outstanding role in the development of monetary policy analysis. I did not know him personally, but I have been very strongly influenced by economists who knew and admired him greatly--Karl Brunner, Milton Friedman, and Allan Meltzer come to mind immediately. My work has also been influenced by writings coming from the research department of the Federal Reserve Bank of St. Louis, which he directed, and by the availability of monetary data series developed there.

For this lecture I originally had planned a title of "The Evolution of Monetary Policy Analysis, 1973-1998." As it happens, I have decided to place more emphasis on today's situation and less on its evolution. But, a few words about history may be appropriate. I had chosen 1973 as the starting point for a review because there was a sharp break in both academic analysis and in real-world monetary institutions during the period around 1971-73. Regarding institutions, of course, I am referring to the breakdown of the Bretton Woods exchange-rate system, which was catalyzed by the U.S. government's decision in August 1971 not to supply gold to other nations' central banks at $35 per ounce. This abandonment of the system's nominal anchor naturally led other nations to be unwilling to continue to peg their currency values to the (overvalued) U.S. dollar, so the par-value arrangements disintegrated. New par values were painfully established during the December 1971 meeting at the Smithsonian Institution, but after a new crisis, the system crumbled in March 1973.

In terms of monetary analysis, the starting date of 1973 has the disadvantage of missing the publication in 1968 and 1970 of the Andersen-Jordan (1968) and Andersen-Carlson (1970) studies, which many of you will know were written at the St. Louis Fed under the directorship of Homer Jones. These studies were, to an extent, a follow-up to the Friedman-Meiselman (1963) paper, which had set off a period of intellectual warfare between economists of a then-standard Keynesian persuasion and those who were shortly (Brunner, 1968) to be termed "monetarists," [1] But my reason for beginning slightly later is that the years 1971-73 featured the publication of six papers that initiated the rational expectations revolution. The most celebrated of these is Lucas's (1972a) "Expectations and the Neutrality of Money," but his other papers (1972b) and (1973) also were extremely influential as were Sargent's (1971 and 1973). The sixth paper is Walters (1971), which had little influence but was, I believe, the first publicatio n to use rational expectations (RE) in a macro-monetary analysis.

At first there was much resistance to the RE hypothesis, partly because it initially was associated with the policy-ineffectiveness proposition. But, it gradually swept the field in both macro and microeconomics, primarily because it seems extremely imprudent for policy analysis to be conducted under the assumption that any particular pattern of expectational errors will prevail in the future--and ruling out all such patterns implies RE.

There were other misconceptions regarding rational expectations, the most prominent of which was that Lucas's famous "critique" paper (1976) demonstrated that policy analysis with econometric models was a fundamentally flawed undertaking. Actually, of course, Lucas and Sargent showed instead that certain techniques were flawed, if expectations are indeed rational, and that more sophisticated techniques are called for. But by 1979, John Taylor, last year's Homer Jones lecturer, had demonstrated that these techniques are entirely feasible. Nevertheless, this misunderstanding--and others concerning the role of money [2]--led to a long period during which there was a great falling off in the volume of sophisticated, yet practical, monetary policy analysis. One reason was the upsurge of the real-business-cycle (RBC) approach to macroeconomic analysis, which in its standard version assumes that price adjustments take place so quickly that, for practical purposes, there is continuous market clearing for all commodi ties, including labor. …