Academic journal article Review - Federal Reserve Bank of St. Louis

Measuring Systematic Monetary Policy / Commentary

Academic journal article Review - Federal Reserve Bank of St. Louis

Measuring Systematic Monetary Policy / Commentary

Article excerpt

The financial press hangs on the words of every Governor of the Federal Reserve Board, every President of a Federal Reserve Bank, and most of all, of course, on the words of Chairman Alan Greenspan. In his testimony to the Senate Banking Committee on July 20, 2000, Greenspan said:

Most recently we have needed to raise rates to relatively high levels in real terms in response to the side effects of accelerating growth and related demand-supply imbalances. Variations in the stance of policy-- or keeping it the same-in response to evolving forces are made in the framework of an unchanging objective-to foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate possible ... Irrespective of the complexities of economic change, our primary goal is to find those policies that best contribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal.

Chairman Greenspan is well known for his inscrutability; yet the message here is exactly the one that the financial markets read into Federal Reserve policy: while ultimately it may aim to control inflation, it does so through contingent responses to inflation and real developments, and it expects its policy actions to affect the real economy systematically. The manner in which the Federal Reserve determines these contingent responses is central in the analysis of optimal policy-- reactions function-provided, of course, that the Fed is right and that systematic monetary policy does have economically significant effects on the real economy.

Starting in the early 1970s, new classical economists led by Robert Lucas began to question whether systematic monetary policy in fact had the required real effects. Over time, many macroeconomists have come to believe that, because of substantial frictions (e.g., price stickiness and limited participation in financial markets), systematic monetary policy does matter. Recent empirical analysis of monetary policy has typically used the econometric framework of vector autoregressions (VARs), Motivated in large measure by Lucas's argument that the coefficients of estimated macroeconomic relationships should not be invariant to changes in monetary-policy regime (the "Lucas critique"), practitioners have focused on unanticipated and unsystematic policy shocks. These shocks account for little of the variability of the instruments of monetary policy and, naturally, are of less interest to markets or politicians than is systematic policy. Yet the way in which VARs are interpreted implicitly assumes that Lucas's original argument-- that systematic monetary policy is ineffective-is correct. There is a logical disconnection between the usual way in which VARs are interpreted and the belief that systematic monetary policy matters.

The aim of this paper is to analyze systematic monetary policy in a VAR framework in a way that is logically consistent. The key insight-originally by John Cochrane (1998)-is that the effect of systematic monetary policy depends on the balance of economic actors between those who behave as ideal new classical agents (frictionless competitors with rational expectations) and those who follow rules of thumb or face other frictions. Our own innovation is to suggest a method of using regime changes (the Lucas critique) to identify that balance empirically. Our purpose is both critical (we try to understand some of the recent literature in a common framework) and positive (we present an empirical assessment of U.S. monetary policy).

1. MONETARY POLICY AFTER LUCAS AND SIMS

Before the 1970s quantitative monetary-policy analysis had two important features. Orthodox monetary policy was typically viewed in a target-- and-instruments framework in which the monetary authority sought to achieve a goal for inflation, gross domestic product (GDP), or unemployment using money or some more directly controllable monetary instrument as the means. …

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