Academic journal article Federal Reserve Bank of St. Louis Review

The Importance of Being Predictable

Academic journal article Federal Reserve Bank of St. Louis Review

The Importance of Being Predictable

Article excerpt

It is a pleasure to participate in this conference and join in the recognition of Bill Poole. My remarks build on two of Bill Poole's important contributions to monetary theory: his 1970 Quarterly Journal of Economics (QJE) paper on monetary policy under uncertainty and his more recent series of lucid short papers on predictability, transparency, and policy rules, many of which were adapted from speeches and published in the Review of the Federal Reserve Bank of St. Louis.

At the same time I want to express my appreciation for Bill's extraordinary service in public policy: starting in the 1960s as a member of the staff of the Federal Reserve Board, where he wrote his 1970 QJE paper and many others; then later as a member of the President's Council of Economic Advisers during the difficult disinflation of the early 1980s, where his role in explaining and supporting the Fed's price stability efforts was essential; and most recently as president of the Federal Reserve Bank of St. Louis, where his emphasis on good communication and good policy has contributed, and will continue to contribute, to improvements in the conduct of monetary policy. Regarding these contributions I give two of my favorite examples of Bill Poole's many pithy phrases which I hope will ring in monetary policymakers' ears for many years to come: "We ignore the behavior of the monetary aggregates at our peril" (Poole, 1999); and "Clearly, more talk does not necessarily mean more transparency" (Poole, 2005a).

THE BEGINNINGS OF RESEARCH ON POLICY RULES IN STOCHASTIC MODELS CIRCA 1970

Let me begin by reviewing Bill Poole's deservedly famous 1970 QJE article. In my view, that paper conveyed two novel messages, one about dealing with uncertainty and the other about reducing uncertainty.

An Approach to Monetary Polio/That Could Deal with Existing Uncertainty

The first message was presented in the form of a simple graphical ISLM analysis, and soon after textbook writers incorporated this analysis in their macroeconomics and money and banking textbooks. At the time Poole wrote his paper, the typical IS and LM curves were drawn without a notion that they could move around stochastically. Bill Poole showed how adding exogenous disturbances to the curves provided a simple framework for monetary policy decisionmaking under uncertainty.

While the framework was simple, the message was extremely useful: When shocks to money demand are very large, central banks should target the interest rate because those shocks would otherwise cause harmful swings in interest rates. When shocks to investment demand or consumption demand are very large, central banks should target the money supply because the interest rate will move to mitigate these demand shocks. Hence, the Poole analysis showed explicitly how policymakers could deal with exogenous uncertainty in a formal mathematical way.

An Approach to Monetary Policy That Could Reduce Uncertainty

The second message was more complex and profound, and also more relevant for my purpose here. Poole investigated what he called a "combination policy" involving both the interest rate and the money supply, and he examined its properties in an economy-wide dynamic stochastic model. The model, with the combination policy inserted, could be written as a vector autoregression. Poole showed how to compute the steady-state stochastic distribution implied by the model. He also showed how to find the optimal policy to minimize the variance of real gross domestic product (GDP) around the mean of this stochastic steady-state distribution. The method involved finding the homogeneous and particular parts of the solution and then writing the endogenous variable as an infinite weighted sum of lagged shocks--what is now commonly called an impulse response function.

The combination policy had key features of active monetary policy rules in use today. The policy involved the money supply (M), the interest rate (r), and lagged values of real GDP (Y). …

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