Magazine article Regional Economist

Models and Monetary Policy: More Science Than Art?

Magazine article Regional Economist

Models and Monetary Policy: More Science Than Art?

Article excerpt

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). …

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