"Over time more complex empirical models with rational expectations and sticky prices (new Keynesian) provided better underpinnings for this monetary policy framework. Many of the new models were international with highly integrated capital markets and no-arbitrage conditions on the term-structure. Soon the new Keynesian FRB/US, FRB/Global and SIGMA models replaced the MPS and MCM models at the Fed. The objective was to find monetary policy rules which improved macroeconomic performance. The Taylor Rule is an example, but, more generally, the monetary policy framework found that rules-based monetary policy led to better economic performance in the national economy as well as in the global economy where an international Nash equilibrium in “rule space” was early optimal.
This was the monetary policy framework that was in place at the time of the financial crisis. Many of the models that underpinned this framework can be found in the invaluable archives of the Macro Model Data Base (MMB) of Volker Wieland where there are many models dated 2008 and earlier including the models of Smets and Wouters, of Christiano, Eichenbaum, and Evans, of De Graeve, and of Taylor. Many models included financial sectors with a variety of interest rates; the De Graeve model included a financial accelerator. The impact of monetary shocks was quite similar in the different models, as shown here and summarized in the following chart of four models, and simple policy rules were robust to different models.
Perhaps most important, the framework worked in practice. There is overwhelming evidence that when central banks moved toward more transparent rules-based policies in the 1980s and 1990s, including through a focus on price stability, there was a dramatic improvement compared with the 1970s when policy was less rule-like and more unpredictable. Moreover, there is considerable evidence that monetary policy deviated from the framework in recent years by moving away from rule-like policies, especially during the “too low for too long” period of 2003-2005 leading up to the financial crisis, and that this deviation has continued. In other words, deviating from the framework has not worked.Have the economic relationships and therefore the framework fundamentally changed since the crisis? Of course, as Tom Sargent puts it in his editorial review of the forthcoming Handbook of Macroeconomics by Harald Uhlig and me, “both before and after that crisis, working macroeconomists had rolled up their sleeves to study how financial frictions, incentive problems, incomplete markets, interactions among monetary, fiscal, regulatory, and bailout policies, and a host of other issues affect prices and quantities and good economic policies.” But, taking account of this research, the overall basic macro framework has shown a great degree of constancy as suggested by studies in the new Handbook of Macroeconomics. For example, Jesper Linde, Frank Smets, and Raf Wouters examine some of the major changes—such as the financial accelerator or a better modeling of the zero lower bound. They find that these changes do not alter the behavior of the models during the financial crisis by much. They also note that there is little change in the framework—despite efforts to do so—to incorporate the impact of unconventional policy instruments such as quantitative easing and negative interest rates. In another paper in the new Handbook, Volker Wieland, Elena Afanasyeva, Meguy Kuete, and Jinhyuk Yoo examine how new models of financial frictions or credit constraints affect policy rules. They find only small changes, including a benefit from including credit growth in the rules.
All this suggests that the crisis did not reveal that the previous consensus framework for monetary policy should be fundamentally reconsidered, or even that it has fundamentally changed. This previous framework was working. The mistake was deviating from it. Of course, macroeconomists should keep working and reconsidering, but it’s the deviation from the framework—not the framework itself—that needs to be fundamentally reconsidered at this time. I have argued that there is a need to return to the policy recommendations of such a framework domestically and internationally.
We are not there yet, of course, but it is a good sign that central bankers have inflation goals and are discussing policy rules. Janet Yellen’s policy framework for the future, put forth at Jackson Hole in August, centers around a Taylor rule. Many are reaching the conclusion that unconventional monetary policy may not be very effective. Paul Volcker and Raghu Rajan are making the case for a rules-based international system, and Mario Draghi argued at Sintra in June that “we would all clearly benefit from enhanced understanding among central banks on the relative paths of monetary policy. That comes down, above all, to improving communication over our reaction functions and policy frameworks.”"