Monetary Policy Analysis. (Research Summaries)

By McCallum, Bennett T. | NBER Reporter, Spring 2002 | Go to article overview

Monetary Policy Analysis. (Research Summaries)


McCallum, Bennett T., NBER Reporter


The past several years have seen very rapid development in the area of monetary policy analysis. (1) One welcome aspect is the convergence of approaches used by academic and central-bank economists. For example, a look at a notable NBER conference volume (2) and/or a special issue of the Journal of Monetary Economics (Vol. 43, July 1999) suggests that it would be difficult, if not impossible, to identify the author of almost any article or comment as belonging to one group or the other. A major stimulus to this convergence, I believe, was John Taylor's exposition of the now-familiar "Taylor Rule," (3) which encouraged academics to focus on policy rules expressed in terms of interest-rate instruments (thereby conforming to actual central bank practices) and encouraged central bankers to think of policy in a more rule-like fashion.

Mainstream Analysis

Much of this recent work has used the following approach: the researcher specifies a quantitative macroeconomic model that is intended to be structural (invariant to policy changes) and consistent with both theory and evidence. Then, analytically or by stochastic simulations, he determines how crucial variables such as inflation and the output gap behave on average under various hypothesized policy rules. Normally, rational expectations is assumed throughout. Evaluation of the outcomes can be accomplished by reference to an explicit objective function or left to the judgement (that is, implicit objective function) of the policymaker. Optimal control techniques may or may not be involved.

There is also considerable agreement about the general, broad structure of the macroeconomic model to be used -- hut much disagreement over details. For the simplest closed-economy analysis a three-equation system is often used, involving just 1) an optimizing "IS" type of intertemporal spending relation; a price adjustment relation; and 2) an interest rate policy rule of the general Taylor type. The basic logic of the analysis is not affected if (1) and (2) are sets of equations representing "sectors" of the model, rather than single equations. A major development over the past 10-15 years is the tendency of researchers to use versions of (1) and (2) that are based on optimizing analysis of individual agents in a dynamic, stochastic setting. Often the price adjustment relation is based on the work of Calvo and Rotemberg, although there continues to be much dispute concerning the theoretical and empirical adequacy of this specification. (4) Development of the optimizing or "expectational" IS relationship -- b asically a consumption Euler equation plus some substitutions -- was affected more or less simultaneously by a number of independent analysts. (5) My own paper with Edward Nelson was not the first in print, but is arguably the only one to explore the relationship of the new expectational specification with IS specifications of the traditional type.

Extensions and Differences

More generally, my recent work has conformed in large measure to the approach just outlined. Papers with Nelson appear in both the Taylor volume and the JME issue mentioned earlier. (6) The former represents a policy-rule exploration based on an estimated model that is highly orthodox in most respects; the latter features an extension, however, that makes the model applicable to a small open economy. We derive import demand as part of the optimizing behavior of consumer-producer households, with imports being modelled as intermediate goods used in the production of consumables, rather than as consumption goods in the manner favored in most of the "new open-economy macro" literature. In a subsequent paper, Nelson and I show that this alternative formulation is helpful in matching some features of actual exchange rate behavior. (7)

A second way in which my work represents an extension of the basic model concerns the role of capital. Much of the literature treats the stock of productive capital as fixed or exogenous. …

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