Academic journal article Journal of Money, Credit & Banking

Expectations and the Effects of Monetary Policy

Academic journal article Journal of Money, Credit & Banking

Expectations and the Effects of Monetary Policy

Article excerpt

This paper examines the predictive power of shifts in monetary policy, as measured by changes in the real federal funds rate, for output, inflation, and survey expectations of these variables. We find that policy shifts have larger effects on actual output than on expected output; thus, policy predicts errors in output expectations, a violation of rational expectations. Policy shifts do not predict errors in inflation expectations. We explain these results with a model in which agents systematically underestimate the effects of policy on aggregate demand. This model helps to explain the real effects of policy.

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THERE IS a growing consensus, based on both historical analysis and econometric evidence, that monetary policy has strong effects on real output. There is not, however, any consensus about how to explain this fact. This paper explores the idea that the nonneutrality of policy arises from a failure of rational expectations. Specifically, we present evidence that agents systematically underestimate the effects of policy on aggregate demand.

Our central results concern the predictive power of policy shifts for real output and for expectations of output. We measure policy shifts with changes in the real federal funds rate; expectations are taken from the Survey of Professional Forecasters (SPF). Like previous researchers, we find that increases in the funds rate reduce output at a horizon of roughly a year. A higher funds rate also causes survey respondents to expect lower output, but the effect on expected output is substantially smaller than the effect on actual output. Thus, increases in the funds rate lead systematically to negative errors in output expectations, a violation of rational expectations.

We also examine the predictive power of policy shifts for inflation and for expectations of inflation. Here, we cannot reject rationality. A rise in the real funds rate leads to a fall in inflation at a horizon of 2 years, and a roughly equal fall in expected inflation. Thus, policy shifts do not predict errors in inflation expectations.

Our results add new evidence to the general debate about the rationality of expectations. Most important, we find that rationality fails in a particular direction, one that helps explain the effects of monetary policy. To make this point, we analyze a simple macroeconomic model with sticky prices. In the model, policy is neutral under rational expectations. We show, however, that policy is nonneutral if agents systematically underestimate the effects of policy on aggregate demand. Crucially, this assumption about expectations also produces results that match our empirical findings: policy shifts predict surprises in real output but not surprises in inflation. Thus, our empirical results support our explanation for nonneutrality.

The remainder of this paper contains four sections. Section 1 describes our empirical methodology, and Section 2 presents the results. Section 3 interprets the results using our model, and Section 4 concludes.

1. METHODOLOGY

We explore the predictive power of shifts in monetary policy for three output variables: actual output, survey expectations of output, and the difference between the two. We perform a similar procedure for inflation. Here, we describe the details of our approach.

1.1 The Basic Regressions

We measure output by real GNP (or GDP starting in 1992) and inflation by the GNP (GDP) deflator. For both variables, expectations are given by the mean forecast from the SPF. In an earlier version of this paper (Ball and Croushore 1995), we also examined expectations from the Livingston survey of business economists and the Michigan survey of consumers. One might expect the behavior of expectations to vary across the surveys because of the different levels of sophistication of forecasters, general economists, and consumers. It turns out, however, that our results are similar for all three surveys. …

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