Central Bank Misperceptions and the Role of Money in Interest Rate Rules Günter W. Beck University of Frankfurt and CFS Volker Wieland ECB*, CFS and University of Frankfurt National Bank of Belgium Conference Brussels, October 17, 2008 Disclaimer: Duisenberg Research Fellow. The views expressed should not be attributed to the European Central Bank or its staff.

Monetary policy rules and money: Taylor, Friedman, Woodford, Lucas Taylor‘s journey from money growth rules to interest rate rules, cf.Taylor (2006): “Taylor (1979) showed that a fixed money growth rule – a Friedman rule - would have led to better performance than actual policy in the post World War II period ... (but) a money growth rule which responded to economic developments could do even better.” “Since then I have found that policy rules in terms of interest rates have worked better as practical guidelines for central banks.”

Friedman (06) taking Taylor‘s perspective with i instead of m as instrument “The Taylor rule is an attempt to specify the federal funds rate that will come closest to achieving the theoretically appropriate rate of monetary growth to achieve a constant price level or rate of inflation.” “Suppose… a Taylor rule that gives 100 percent weight to inflation deviations. That may not be the right rate..because other variables such as output or monetary growth are not at their equilibrium levels.” “..additional terms in the Taylor rule would reflect variables relevant to choosing the right target funds rate to achieve the desired inflation target.”

Are monetary aggregates relevant for monetary policy design? New- (and traditional) Keynesian models - No! Woodford (2006) writes: „Serious examination of the reasons given thus far for assigning a prominent role to monetary aggregates in (policy) deliberations provides little support for a continued emphasis on those aggregates“. Lucas (2007) expresses some concern regarding the increasing reliance of central bank research on New-Keynesian modeling.

Are monetary aggregates relevant for monetary policy design? New- (and traditional) Keynesian models - No! Lucas (2007) expresses the following concerns: „Money supply measures play no role in the estimation, testing or policy simulation of these (NK) models …formulated in terms of deviations from trends that are determined off stage … (they) could be reformulated to give a unified account of trends, including monetary aggregates, and deviations ...” „This remains an unresolved issue on the frontier of macroeconomic theory. Until it is resolved, monetary information should continue be used as a kind of add-on or cross-check.”

Lucas (2007) on money and NK models „Money supply measures play no role in the estimation, testing or policy simulation of these models …formulated in terms of deviations from trends that are determined off stage … (they) could be reformulated to give a unified account of trends, including monetary aggregates, and deviations ...” „This remains an unresolved issue on the frontier of macroeconomic theory. Until it is resolved, monetary information should continue be used as a kind of add-on or cross-check.”

Our objective Show that central bank misperceptions regarding unobservable equilibrium values may be at the root of proportional money growth and inflation trends. Propose an approach to cross-checking with money (extend Beck and Wieland, JEEA 2007). Helps avoid persistent deviations from the inflation target in the event of misperceptions such as those observed historically. Show that cross-checking remains effective with velocity shifts. Investigate benefits from nonlinearity of cross-checking and from alternative measures for cross-checking in place of money.

Outline Our use of output gap misperceptions and optimal policy design (helps avoid some a-priori assumptions on unobservables). Explaining money and inflation trends Cross-checking monetary trends in interest rate policy Some additional questions Conclusions

1. Output gap misperceptions and optimal policy Traditional and New-Keynesian Phillips curves. K-Model: NK-Model:

Policy objective Loss function (strict inflation targeting, i.e. output gap only matters because of Keynesian view that it determines inflation.) First-order condition

Optimal policy Output level that achieves foc is: Optimal policy under uncertainty:

Standard approach: a-priori assumptions regarding unobservables Typically, optimal policy is determined conditional on some a-priori assumptions regarding unobservables such as potential output, productivity trends, etc.. For example, Svensson and Woodford (2003) or Wieland (2006) use with known persistence parameter and shock distribution.

Separation of control and estimation Certainty-equivalence applies, separate control and estimation (Kalman filter), optimal policy responds linearly to best, model-consistent estimate of output gap. The optimal value of the interest rate follows from the IS equation:

Optimal interest rate policy May be expressed as Taylor-style policy rules. In K-model, it is typically assumed that no information on shock is available, in NK typically a signal is given:

The irrelevance of monetary aggregates Include money demand But it is determined recursively and does not show up in optimal interest rate policy on right-hand-side. (open-market operations implemented to achieve prescribed interest rate)

Use historical misperceptions and avoid a-priori assumptions Use real-time potential and output gap estimates from Orphanides (2003) and Gerberding et al (2007), compared to final estimates (1994 for Orphanides). Misperception et: Perceived potential:

U.S. output gap misperceptions Orphanides, The quest for prosperity without inflation, Journal of Monetary Economics, 2003.

The Bundesbank‘s output gap misperceptions Gerberding, Seitz, Worms, How the Bundesbank really conducted policy, North American Journal of Economics and Finance, 2005.

Historical output gap misperceptions US: Orphanides, The quest for prosperity without inflation, J.Monetary Economics, 2003. Germany: Gerberding, Seitz, Worms, How the Bundesbank really conducted policy, North American Journal of Economics and Finance, 2005.

2. Explaining money and inflation trends Why Lucas (2007) talks about trends: Chart from Benati (2005), see also Gerlach (2004), and others.

Explanations Literature: random walk inflation targets Our paper: constant target but central bank misperceptions with regard to potential output (or equilibrium real interest rates).

Relate money and inflation trends NK/K model: Empirically: filtered measures (Gerlach, others)

Misperceptions cause proportional money and inflation trends K-Model / US misperceptions (single draw of other shocks)

Inflation inherits dynamics of misperceptions

Misperceptions cause proportional money and inflation trends (ave 1000 draws)

3. Cross-checking Recall policy design conditional on Keynesian model: consequently,

Alternatively, a Friedman-type monetarist... .. would expect trend inflation to follow long-run money growth: and conduct open-market operations such that

Of course, if the Keynesian models are correct, then .... the same implications for trend inflation and trend money growth will apply.  Introduce a test statistic for a mean shift: ... and check if κ>κcrit or κ< -κ crit for N periods.

If cross-check signals shift, then ... set policy such that

Policy following a significant cross-check These policies consist of two components:

Cross-checking in the NK model US misperceptions

Cross-checking in NK model German misperceptions

1000 draws: K/NK-US/DE with cross-checking

4. Further questions. Linear rules with adjustment are suboptimal (2 cases, with and without misperceptions). Persistent velocity shifts (money demand parameters change) can be accounted for by re-estimating money demand equations regularly (Orphanides and Porter 2000, 2001). Other trend inflation measures, such as filtered inflation work too. Recall, there is not lead of money growth on inflation in this model. (Future work consider models that can generate a lead of money growth on inflation).

Linear versus Nonlinear Policies

Persistent Velocity Shifts Shifting intercept and recursive estimation (Orphanides and Porter 2000, 2001).

Persistent Velocity Shifts

Other Cross-Checks

5. Conclusions New explanation of empirical findings on money growth and inflation trends. Implement Lucas proposal of monetary cross-checking (ECB ? ) Cross-checking may be useful general concept in the case of decision making under model uncertainty, (no requirement to restrict focus to money).