Recent Developments in Monetary Policy Analysis: The Roles of Theory and Evidence
McCallum, Bennett T., Economic Quarterly - Federal Reserve Bank of Richmond
Academic thinking about monetary economics-as well as macroeconomics more generally-has altered drastically since 1971-1973 and so has the practice of monetary policy. The former has passed through the rational expectations and real-business-cycle revolutions into today's "new neoclassical synthesis" whereas policymaking has rebounded, after a bad decade following the breakdown of the Bretton Woods system, into an era of low inflation that emphasizes the concepts of central bank independence, transparency, and accountability while exhibiting substantial interest in the consideration of alternative rules for the conduct of monetary policy.1
My assignment in this paper is to consider the roles of economic theory and empirical evidence in bringing about these changes-in particular, changes in policy formulation. Have they been driven primarily by theoretical reasoning or by accumulated evidence? As a related matter, has the evolution reflected health or sickness in the macro-monetary branch of economic science?
In discussing actual monetary policymaking, there is a difficulty stemming from the possibility that in practice policy choices are dominated by responses to current political pressures, with economic reasoning of any form playing a strictly subordinate role in the thought processes of voting members of policymaking bodies such as the United States Federal Open Market Committee. There is reason to believe, however, that economic analysis has been playing an increasing role in monetary policy considerations and, in any event, there would be little for economists to discuss if we were to conclude that actual policy is independent of such analysis. Consequently, most of the discussion below will take writings of central bank economists, together with official publications such as inflation reports, as providing some indication of actual monetary policy practices.
Also, it should be admitted at the outset that evaluation of the relative contributions of theory and evidence is extremely difficult. In fact, a proper quantitative evaluation is probably impossible, since economic science evolves by way of a complicated back-and-forth interaction of theoretical and empirical considerations. Moreover, these considerations are often combined in the work of a single analyst; for example, most of the researchers listed below in Table 1 rely on such a combination in their own work. Consequently, some of this back-and-forth takes place within the minds of individual researchers and thus may not show up at all in the exposition of papers written to report results. Under such circumstances, it is clear that measurement of the relative contributions of theory and evidence must be highly problematic, at best. Accordingly, what is presented in this paper might be regarded more as a number of observations relevant to the issue, rather than as an actual evaluation. My hope is that these observations will shed some light on the evolution of monetary analysis while establishing that both theory and evidence have played important roles.
The outline of the paper is as follows. In Section 2, general analytic trends in macroeconomics will be briefly outlined as a background. Then Section 3 takes up the evolution of monetary policymaking in practice and Section 4 does the same for the formal analysis of monetary policy. Section 5 treats a special topic and Section 6 concludes.
2. TRENDS IN MACROECONOMICS, 1973-1998
The years 1971-1973 make a good starting point for our discussion because they mark sharp breaks in both macroeconomic thinking and in institutional arrangements relevant to the conduct of monetary policy. In terms of institutions, of course I have in mind the breakdown of the Bretton Woods exchange-- rate system, which was catalyzed by the United States's decision of 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. …