Ebook Monetary Rules, Indeterminacy, and the Business-Cycle Stylised Facts
In recent years, several papers–see in particular Clarida, Gali, and Gertler (2000) and Lubik and Schorfheide (2004)–have documented marked changes in the conduct of U.S. monetary policy over the post-WWII era. Specifically, the reaction function of the U.S. monetary authority is estimated to have been passive, and destabilising, before Volcker, and active and stabilising since then.
A second group of studies see, e.g., Kim and Nelson (1999), McConnell and Perez-Quiros (2000), Kim, Nelson, and Piger (2003), and Stock and Watson (2002)–has documented a marked increase in U.S. economic stability over (roughly) the last two decades, with the volatility of reduced-form innovations to both inflation and output growth being estimated to have drastically fallen compared to previous years.
These two strands of literature prompt two obvious questions:
- (1) ‘What is the relationship between historical changes in the conduct of U.S. monetary policy and the increase in U.S. economic stability?’
(2) ‘At a more general level, what is the impact of changes in the conduct of monetary policy on key macroeconomic ‘stylised facts’, like inflation persistence, or the amplitude of business-cycle frequency fluctuations?’
In this paper we first compare and constrast the two sub-periods preceding and, respectively, following the appointment of Paul Volcker as Chairman of the Board of Governors of the Federal Reserve System in terms of a number of key business-cycle ‘stylised facts’. The latter period appears to be characterised by a lower inflation persistence; a smaller volatility of reduced-form innovations to inflation and output growth; and a systematically lower amplitude of business-cycle frequency fluctuations for all the macroeconomic indicators we consider, with the only exception of base money growth. Finally, consistent with Brainard and Perry (2000)’s finding of a decrease in the slope of the U.S. Phillips curve over the last two decades, the gain and the coherence between cyclical indicators (the rate of unemployment, and an ‘activity factor’ constructed along the lines of Stock and Watson (1999b)) and inflation at the business-cycle frequencies appear to have decreased, after 1979, compared with the pre-Volcker era, although the change is not statistically significant at conventional levels.
Working with the sticky-price, sticky-wage DSGE model of the U.S. economy recently estimated via Bayesian methods by Smets and Wouters (2003), and preliminarly, to build intuition, with the standard workhorse New Keynesian model of Clarida, Gali, and Gertler (1999), we then investigate how such stylised facts change systematically with changes in the coefficients on inflation and the output gap in a simple Taylor rule. Given that, as documented in the previously mentioned papers, the pre-Volcker period appears to have been characterised by a passive monetary rule, we do not restrict our investigation uniquely to the determinacy region, solving the model under indeterminacy via the procedure recently introduced by Lubik and Schorfheide (2003). The determinacy and indeterminacy regions appear to be characterised by a markedly different set of macroeconomic stylised facts. Further, in several cases the relationship between the parameters of the monetary rule and key stylised facts under indeterminacy is a sort of mirror image of what it is under determinacy: both inflation persistence and the volatility of its reduced-form innovations, for example, are increasing in the coefficient on inflation under indeterminacy, decreasing under determinacy.
Finally, we compare the stylised facts identified in the data with those generated by the Smets-Wouters model conditional on estimated monetary rules. Although variation in the monetary rule across sub-periods can, in principle, explain the broad features of the variation in the macroeconomic stylised facts we consider, results are in general not consistent across different inflation measures and output gap proxies. In particular, some of our estimates imply that the pre-Volcker era, too, was characterised by a determinate equilibrium, in spite of the lower activism of the monetary rule.
The paper is organised as follows. The next section describes the dataset. In section 3 we identify key business-cycle stylised facts for the sub-periods of interest. Section 4 investigates the relationship between changes in the conduct of monetary policy, and changes in the very same stylised facts we previously investigated in the data. In section 5 we compare the stylised facts identified in section 4 with those generated by the Smets-Wouters model conditional on estimated forward-looking monetary rules. Section 6 concludes, and outlines several possible directions for future research.
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