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

2. 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

3. 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

5. 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

6. 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)

7. Solving the Models Solution is a stochastic process for yt
In linear fi case
Blanchard-Kahn, eigenvalues, eigenvectors
In non-linear fi case
Iterative methods
Fair-Taylor
simple, user friendly (can do within Eviews), slow
Ken Judd

8. 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

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

10. The Timeless Method for Evaluating Monetary Policy Rules
Stick a policy rule into model fi (.)
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

11. Simple model illustrating expectations effects of policy rule: (1)
Simple model illustrating expectations effects of policy rule:   (1) yt = -(rt + Etrt+1) + t   Policy Rule:   (2) rt = 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(yt) + var(rt)   Observe that Etrt+1 = ht   If h = 0, then by raising h and lowering g one can and get the same variance of yt and a lower variance of rt.

12. 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

13. A simple illustration of an output-inflation variability tradeoff

14. Variance of
output
Variance of inflation

15. Inflation Rate AD
target PA
Real Output
(Deviation)

16. 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…
w1(t - *)2 + w2 (yt – yt*)2
Or minimize this period loss function in the steady state
Try to have y* equal to the “natural” rate of output

21. Historical confirmation: in the U. S
Historical confirmation: in the U.S. the federal funds rate has been close to monetary policy rule I
Percent 12 10 8 6 0% 4 3%
Federal Funds Rate 2 89 90 91 92 93 94 95 96 97 98

22. Smothoed inflation rate (4 quarter average) 812 10
Smothoed inflation rate
(4 quarter average) 8 6
1968.1: Funds
rate was 4.8%
1989.2: Funds
rate was 9.7% 4 2 60 65 70 75 80 85 90

23. percent 4 2 -2
GDP gap with HP trend
for potential GDP -4 -6 60 65 70 75 80 85 90 95

24. percent 20
Real GDP growth rate (Quarterly) 15 10 5 -5
-10 60 65 70 75 80 85 90 95

25. Output Stability Comparisons
Period
gap
growth
1.6
3.6
1.8
4.3
1.1
2.3

26. 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))

27. Interest rate Constant Real Interest Rate Policy Rule Inflation rate
Target

28. Inflation Rate AD PA
Real Output
(Deviation)

29. The role of the exchange rate
Extended policy rule
it = gt + gyyt + ge0et + ge1et it-1
where
it is the nominal interest rate,
t is the inflation rate (smoothed over four quarters),
yt is the deviation of real GDP from potential GDP,
et is the exchange rate (higher e is an appreciation).

31. 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.