The New Normative Macroeconomics John B. Taylor Stanford University XXI Encontro Brasileiro de Econometria 9 December 1999

Some Historical Background Rational expectations assumption was introduced to macroeconomics nearly 30 years ago –now most common expectations assumption in macro –work on improving it ( e.g. learning) continues The “rational expectations revolution” led to –new classical school –new Keynesian school –real business cycle school –new neoclassical synthesis –new political macroeconomic school Now as old as the Keynesian revolution was in early 70s

But this raises a question We know that many interesting schools have evolved from the rational expectations revolution, but has policy research really changed? The answer: Yes. It took a while, but if you look you will see a whole new normative macroeconomics which has emerged in the 1990s –Interesting, challenging theory and econometrics –Already doing some good Policy guidelines for decisions at central banks Helping to implement inflation targeting Constructive rather than destructive Look at –policy models, policy rules, and policy tradeoffs

Characteristics of the Policy Models Similarities –price and wage rigidities combines forward-looking and backward-looking frequently through staggered price or wage setting –monetary transmission mechanism through interest rates and/or exchanges rates –all viewed as “structural” by the model builders Differences –size (3 equations to nearly 100 equations) –degree of openness –degree of formal optimization all hybrids: some with representative agents (RBC style), other based directly on decision rules

Examples of Policy Models Taylor (Ed.) Monetary Policy Rules has 9 models Taylor multicountry model ( Rotemberg-Woodford McCallum-Nelson But there are many many more in this class –Svensson –This conference: Hillbrecht, Madalozzo, and Portugal –Central Bank Research (not much different) Fed: FRB/US Bank of Canada (QPM) Riksbank (similar to QPM) Central Bank of Brazil (Freitas, Muinhos) Reserve Bank of New Zealand (Hunt, Drew) Bank of England (Batini, Haldane)

Solving the Models Solution is a stochastic process for y t In linear f i case –Blanchard-Kahn, eigenvalues, eigenvectors In non-linear f i case –Iterative methods Fair-Taylor –simple, user friendly (can do within Eviews), slow Ken Judd

Policy Rules Most noticeable characteristic of the new normative macroeconomics –interest in policy rules has exploded in the 1990s Normative analysis of policy rules before RE –A.W. Phillips, W. Baumol, P. Howrey –motivated by control engineering concerns (stability) But extra motivation from RE –need for a policy rule to specify future policy actions in order to estimate the effect of policy Dealing constructively with the Lucas critique –time inconsistency less important

Policy Rule Constant Real Interest Rate Interest rate Inflation rate Target Example of a Monetary Policy Rule

The Timeless Method for Evaluating Monetary Policy Rules Stick a policy rule into model f i (.) Solve the model Look at the properties of the stochastic steady state distribution of the variables (inflation, real output, unemployment) Choose the rule that gives the most satisfactory performance (optimal) –a loss function derived from consumer utility might be useful Check for robustness using other models

Simple model illustrating expectations effects of policy rule: (1)y t = -  (r t + E t r t+1 ) +  t Policy Rule: (2)r t = g  t + h  t-1 Plug in rule (2) into model (1) and find var(y) and var(r). Find policy rule parameters (g and h) to minimize var(y t ) + var(r t ) Observe that E t r t+1 = h  t If h = 0, then by raising h and lowering g one can and get the same variance of y t and a lower variance of r t.

Policy Tradeoffs Original Phillips curve was viewed as a policy tradeoff: could get lower unemployment with higher inflation –but theory (Phelps-Friedman) and data (1970s) proved that there is no permanent trade off But there is a short run policy tradeoff –at least in models with price/wage rigidities –even in models with rational expectations New normative macroeconomics characterizes the tradeoff in terms of the variability of inflation and unemployment

A simple illustration of an output-inflation variability tradeoff

Variance of output Variance of inflation

Inflation Rate Real Output (Deviation) AD PA 0 target 

Inflation targeting Keep inflation rate “close” to target inflation rate In mathematical terms: minimize, over an “infinite” horizon, the expectation of the sum of the following period loss function, t = 1,2,3… w 1 (  t -  * ) 2 + w 2 (y t – y t * ) 2 Or minimize this period loss function in the steady state Try to have y* equal to the “natural” rate of output

Historical confirmation: in the U.S. the federal funds rate has been close to monetary policy rule I Percent Federal Funds Rate 0% 3%

Smothoed inflation rate (4 quarter average) : Funds rate was 4.8% : Funds rate was 9.7%

percent GDP gap with HP trend for potential GDP

percent Real GDP growth rate (Quarterly)

Output Stability Comparisons Period  gap  growth

Interest rate hitting zero problem To estimate likelihood of hitting zero and getting stuck, put simple policy rule in policy model and see what happens: –pretty safe for inflation targets of 1 to 2 percent Modify simple rule: –Interest rate stays near zero after the expected crises (Reifschneider and Williams (1999))

Policy Rule Constant Real Interest Rate Interest rate Inflation rate 0 Target

Inflation Rate Real Output (Deviation) AD PA 0

The role of the exchange rate Extended policy rule i t = g   t + g y y t + g e0 e t + g e1 e t-1 +  i t-1 where i t is the nominal interest rate,  t is the inflation rate (smoothed over four quarters), y t is the deviation of real GDP from potential GDP, e t is the exchange rate (higher e is an appreciation).

In conclusion The “new normative macroeconomics” is currently a huge and exciting research effort –it demonstrates how policy research has changed since the rational expectations revolution –it has probably improved policy decisions already in some countries With a great amount of macro instability still existing in the world there is still much to do.