1 Günter W. Beck and Volker Wieland University of Frankfurt and Center for Financial Studies Conference on „John Taylor‘s Contributions to Monetary Theory and Policy“ Dallas, October 12-13, 2007 Central Bank Misperceptions and the Role of Money in Interest Rate Rules

2 Cast in order of appearance in this paper  Policy rules ( Taylor‘s rule)  Inflation and output volatilities under uncertainty (Taylor‘s curve)  Learning and policy design (Taylor‘s dissertation)

3 Monetary policy rules and money: Taylor, Friedman, Woodford, Lucas  Taylor‘s interest in developing effective rules for government policy has been a driving force for his research, 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.”

4 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.”

5 So add money as a right-hand-side variable in a Taylor-style rule?  New-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.

6 Money as a cross-check?  Lucas (2007):  „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.”

7 Our objective 1.Incorporate cross-checking with regard to monetary trends in Taylor-style interest rate rules, (Beck and Wieland, JEEA 2007). 2.Use historical output gap misperceptions to show that central bank beliefs cause persistent policy errors and drive money and inflation trends. 3.Show that monetary cross-checking improves inflation control by correcting repeated policy errors. 4.Show that monetary cross-checking even remains effective in case of sustained velocity shifts, if the central bank learns – i.e. recursively estimates money demand allowing for shifts.

8  Interest rate rule with 2 components: (1) i T : could by Taylor-style rule, or the interest rate policy implied by loss function minimization in a given model. i M : refers to the interest-rate adjustment due to cross-checking. Systematic, but infrequent, triggered by a statistical test of a key relationship! 1. Cross-checking

9 Step 1: Cross-checking trend in adjusted money growth against the inflation target and testing for a mean shift: (2) i.e. check if κ>κ crit or κ< -κ crit for N periods. Monetary cross-checking

10 Step 2: If there is evidence for a shift then change interest rate levels appropriately. (3)... change if κ>κ crit or κ< -κ crit for N periods. Monetary cross-checking

11 Why cross-check with a monetary (trend) measure?  Why Lucas talks about trends (Benati 2005)

12 (4) Money demand (5) Money growth and inflation in the short-run (6) Money growth and inflation in the long-run Deriving the monetary (trend) measure for cross-checking

13 The monetary (trend) measure for cross-checking (7) Long-run empirics: filtered adjusted money growth moves with filtered inflation. (8) Definiton of filter as in Gerlach (2004).

14 Strategy for evaluating role of money  Consider 2 models (eqn‘s in Table 1, page 11)  Keynesian-style model (K-model) as in Svensson (1997), Orphanides&Wieland (2000).  New-Keynesian model (NK-Model) as in Clarida, Gali and Gertler (1999).  Optimal policy expressed as Taylor-style rule  K-Model: Taylor rule with lagged inflation and output gap, but coefficients greater than 0.5.  NK Model: Optimal policy under discretion corresponds to Taylor-style rule with inflation forecast and perceived demand shock.

15 Strategy continued  Show that in both models optimal interest rate policy with historical output gap misperceptions, leads to sustained money and inflation trends.  Misperception: perceived potential differs from true value.

16 Strategy continued  Note, to sharpen the focus we consider a central bank that cares only about inflation deviations from a zero target. Thus, the f.o.c.is:  Then, we apply the same policy rules in conjunction with monetary cross-checking.

17 Policy objective: K-Model: optimal policy under uncertainty Policy objective and optimal interest rate policies

18 Policy objective and optimal interest rate policies NK-Model: Interest rate setting implied by optimal policy under discretion In both cases money does not matter, but inflation forecast depends on output gap and policy.

19 The Models

20 The Parameters

21 Following Clarida, Gali, Gertler (1999): (1) Output gap: (2) Phillips: (3) IS: Note: superscript e ≡ E t A Simple New-Keynesian Model

22 (5) Persistent shocks NK Model Includes Persistent Shocks

23 Noise and Misperceptions in NK Model (9) Noise: Actual shocks differ from perception

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

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

26 2. Money and inflation trends due to historical misperceptions US: Orphanides, The quest for prosperity without inflation, J.Monetary Economics, Germany: Gerberding, Seitz, Worms, How the Bundesbank really conducted policy, North American Journal of Economics and Finance, 2005.

27 Money and inflation trends due to historical misperceptions  Central bank persistently overestimates potential and misperceives the output gap.  As a result, interest rates are set too low for a sustained period of time.  Output ends up higher than required to maintain price stability.  Money growth and inflation rise for a sustained period of time.

28 NK optimal interest rate with misperception  Persistent misperception implies that interest rates are set too low or too high for a sustained period of time.

29 K-Model: US-misperceptions

30 K-Model: US misperceptions Actual and perceived output gap

31 NK-Model: Bundesbank misperceptions

32 Trend measures: K/NK-US/DE 1000 draws

33 3. Misperceptions and cross-checking K-Model: US misperception with cross-checking

34 NK model: Bundesbank misperceptions with cross-checking

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

36 4. Cross-checking and velocity shifts  Monetary cross-checking deals well with velocity fluctuations due to γ y Δy, γ i Δi or Δe.  But what about sustained trends in velocity as identified by Reynard (2004) or Orphanides and Porter (2000, 2001).

37 Sustained velocity shift of 2% when the central bank never revises estimates

38 Sustained velocity shift and cross- checking when central bank learns

39 Conclusions  We have shown that historical central bank misperceptions cause money and inflation trends of similar extend and direction.  We have shown that combining the Taylor-style rules or model-based optimal interest rate policy with monetary cross-checking improves inflation control.  We have shown that monetary cross-checking remains effective in the presence of sustained velocity shifts when the central bank updates its money demand estimates and learns.