Thirty-five years of model building for monetary policy evaluation: breakthroughs, dark ages, and a renaissance

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Author: John B. Taylor
Date: Feb. 2007
From: Journal of Money, Credit & Banking(Vol. 39, Issue 1)
Publisher: John Wiley & Sons, Inc.
Document Type: Article
Length: 4,040 words
Lexile Measure: 1650L

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ONE OF THE most important advances in monetary policy analysis in the past three decades has been the development and use of economy-wide econometric models that combine forward-looking rational expectations and sticky prices or wages. Such models are so commonplace now that the idea hardly deserves comment and indeed the structural models presented at this conference are no exception. But no such models existed at the time that the Econometrics of Price Determination Conference was held 35 years ago. The paper by Robert Lucas (1972a) at that conference presented a rational expectations model, but it had perfectly flexible prices--neither time-dependent price setting, as in the future staggered contract models, nor state-dependent price setting, as in the future menu cost models. Other papers at the 1970 conference--still reflecting what was common in econometric macro models at the time focused on backward-looking models of the wage-price dynamics featuring inflexible markups from wages to prices and adaptive expectations. Expectations of inflation, important for price determination following the Friedman-Phelps hypothesis, were therefore very slow to change unlike in the rational expectations models.

These two separate strands continued to develop in parallel for years following the conference. One strand was formed by the follow-ups to the Lucas conference paper, including his "Expectations and the Neutrality of Money" paper (1972b), his Lucas critique paper (1976), and the policy ineffectiveness paper of Thomas Sargent and Neil Wallace (1975). The other strand was formed by the research work on price adjustment models for policy at the Federal Reserve Board--including the work estimating the wage-price block of the Fed's model.

Like the gap between desired and actual decision variables in an (S, s) model, the gap between actual and desired models for monetary policy evaluation was growing. As the gap grew, the need to close it in some way in order to do monetary policy analysis became clearer. What exactly was this need? First, the Lucas critique presented a convincing case to many researchers that conventional policy analysis was flawed; the critique offered an alternative method of analysis using rational expectations to evaluate monetary policy rules, though most researchers seemed to ignore or misunderstand that alternative, or to think that the alternative was unattractive or too difficult to follow in practice.

Second, monetary policy evaluation required a realistic model of how monetary policy impacted inflation and the real economy, and that required introducing some form of inflexibility in price formation into the rational expectations models, which was not captured either by the rational expectations models with perfectly flexible prices or by the traditional econometric models with backward-looking adaptive expectations. That the form of monetary policy rules did not even matter in the existing rational expectations models, as shown by Sargent and Wallace (1975), made it virtually impossible to evaluate alternative monetary policy rules in those models as the Lucas critique had suggested one should do. (1) That the traditional models did not have forward-looking expectations made them highly susceptible to the Lucas critique.

1. BREAKTHROUGHS

With this pent-up demand for...

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Gale Document Number: GALE|A159962724