Models and Monetary Policy: More Science Than Art?

By Kliesen, Kevin L. | Regional Economist, January 1999 | Go to article overview

Models and Monetary Policy: More Science Than Art?


Kliesen, Kevin L., Regional Economist


According to published minutes of the Federal Open Market Committee meeting held June 30 and July 1, 1998, the FOMC, worried that conditions were ripe for rising inflation, reaffirmed its previous policy position that a "bias toward restraint"-a tightening of monetary policy-was needed. Just four months later, though, confronted with the fallout reportedly stemming from the "Asian contagion," the FOMC decided to lower the federal funds rate-an action the committee repeated in October and November.

Are large-scale macroeconomic forecasting models helpful to the monetary policy process in instances like this? Or, when expectations of the future change suddenly, does a monetary policy-maker instead feel like the circus performer who, while tied to a spinning wheel, faces an onslaught of knives thrown by a blindfolded person?

Policy Challenges

One of the most important challenges confronting U.S. public policy-makers is the design and implementation of economic policies that best promote rising living standards over time. To most monetary policy practitioners, price stability-generally defined as an inflation rate low enough not to factor into the planning horizon of consumers and producers-is the necessary first step to ensuring this outcome. The economy's long-run growth rate, however, is largely influenced by "real" factors that tend to change rather slowly: population growth, labor productivity and the rate of technological advancement. The problem facing monetary policy-makers is that their actions have little direct influence over these factors.

Over shorter horizons, unforeseen economic disturbances-what economists call shocks-can influence economic outcomes. These shocks, if allowed to propagate, can affect the economy's health over the long term. But because these disturbances can't be predicted, gauging their effect is difficult-witness the recent turmoil in Asia that has spread to other regions and affected financal markets worldwide.

In some instances, however, these disturbances have certain traits in common with previous disturbances. For example, Federal Reserve Chairman Alan Greenspan has argued that the Asian situation is similar in many respects to the 1995 Mexican peso crisis. If so, then macroeconomic models may help policy-makers understand how the economy would respond to such a shock. These models may also help policy-makers formulate a policy response that minimizes the effects of these shocks.

To do this effectively requires a model that can systematically predict the change of headline variables like GDP growth, inflation and the unemployment rate. Alas, no model can accomplish all that. To help minimize the uncertain nature of the forecasting business, economists have developed several types of models to help them project the path of the economy over time. Whether any of these models can reliably inform policy-makers of future outcomes in response to unusual events-and thus effectively add to the process-is open to debate, however.

Model Types

The types of models used in the policy process can generally be described as either structural models or forecasting models. Structural models that use a Keynesian systems of equations approach are most prevalent in the policy arena. These models, which can have several hundred equations and identities, attempt to forecast such variables as output (real GDP), prices and employment from the ground up-in other words, as suggested by economic theory.1

In older structural models, such as the Federal Reserve's MPS model, the forward-looking aspect of the model's structure-which is termed expectations-was usually assumed to be a function of past behavior.2 By contrast, in newer structural models, such as the Federal Reserve Board's FRB/US Macroeconomic Model and the International Monetary Fund's MULTIMOD model, the formation of expectations is quite different. These newer models assume that the economy's producers and consumers are rational in their decision-making processes-- in other words, that they know the structure of the economy (and thus the model).

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Models and Monetary Policy: More Science Than Art?
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.