The Monetary Policy Model: "Rational Expectations" Is the Basis for Setting and Understanding Monetary Policy

Article excerpt

Most monetary economists today conduct their analysis within some version of a rational expectations model. A well-defined equilibrium in such a model requires that the private sector understand policy goals and the policymakers' model of the economy. An austere version of the model, with no information asymmetries, is valid only to a first approximation but nevertheless provides core insights to short- and long-run monetary policy. In this model, effective policy requires clarity of policy goals and clarity of the policy model as to how the economy works. The central bank must enjoy sustained credibility in the markets. Communication should focus on policy fundamentals and the monetary authorities' understanding of the economy, both of which are enhanced by continued research by monetary policy experts.

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I am sure that all of us find it sobering to meet on the fifth anniversary of the tragic events of September 11, 2001. Many of you were present at the NABE annual meeting at the World Trade Center that day and were fortunate to escape before the great towers came down.

It is a distinct honor to be here today to accept the Adam Smith Award. I will talk about the subject I know best--monetary policy. I would have used the title, "My Monetary Policy Model" except for the fact that the model I use is not mine.

Our current understanding of monetary economics has been built on contributions over many hundreds of years. In preparing this lecture, I reminded myself of just how clearly Adam Smith understood monetary issues by going back to reread sections of the Wealth of Nations. Smith begins the book with three short chapters on the division of labor. Chapter 4 is entitled, "Of the Origin and Use of Money." Smith explains that division of labor requires exchange, and exchange requires money. He discusses the difficulty of conducting exchange efficiently because metallic money needs to be weighed and assayed. Smith discusses the practice of princes and sovereign states in debasing the currency.

He notes that "such operations, therefore, have always proved favourable to the debtor and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity."

Monetary policymakers are acutely aware of the potential for monetary policy to create "a very great public calamity," and they feel deeply their responsibility not to permit such an outcome. Our most fundamental challenges are basically the same ones Smith noted. Uncertainty over the value of money is one; another is the incentive of sovereign states to debase the value of money. My aim in this lecture is to provide a skeletal picture of how I view the Federal Reserve's task.

Rational Expectations Macroeconomic Equilibrium

Most macroeconomists today adhere to a model based on the idea of a rational expectations equilibrium. All aspects of government policy enter the rational expectations model--the "RE model" for short--but I'll confine my remarks to monetary policy. Policymakers are assumed to have a set of goals and a conception of how the economy works. The private sector understands, to the extent possible, policymakers' views. An equilibrium is characterized by a situation in which the private sector has a clear understanding of policy goals and the policymakers' model of the economy, and the policy model of the economy is as accurate as possible. If the policymakers and private market participants do not have views that converge, no stable equilibrium is possible because expectations as to the behavior of others will be constantly changing. In this setting, market behavior depends centrally on expectations concerning monetary policy and the effects of monetary policy on the economy, including effects on inflation, employment, and financial stability. A stable equilibrium requires that markets behave as policymakers expect and that policymakers behave as markets expect. …