See
Should the Previous Framework for Monetary Policy Be Fundamentally Reconsidered? by John Taylor. Excerpt:
"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.”"
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