One Rule to Ring Them All?

In macroeconomic models, if everything works perfectly — if all markets clear at all points in time, prices are fully and instantaneously flexible, people have the information they need, and so on — then monetary policy will have no affect on real variables such as output and employment. Only nominal variables such as the price level will change. This is known as monetary neutrality.

In order to get non-neutrality, i.e. in order to make it so that changes in the money supply can change real output and employment in a theoretical model, there must be a friction of some sort. One popular friction is price/wage rigidity, but it is not the only type of friction that can generate non-neutralities. Any friction that prevents optimal and instantaneous response to a shock will overcome neutrality and restore the ability of the Fed to affect the course of the real economy.

The point I want to emphasize is that the optimal monetary policy rule depends upon the underlying friction that is being used to generate non-neutralities in the theoretical model. For example, Calvo type price rigidity combined with some sort of social objective function such as maximizing the welfare of the representative household often gives you something that resembles the standard Taylor rule (though whether the level and/or the growth rates of price and output belong on the right-hand side of the Taylor rule depends upon the nature of the friction, i.e. even in this case the standard Taylor rule may not be the optimal rule).

I am willing to believe that during the Great Moderation the standard Taylor rule may have at least been close to the optimal rule. If you believe price frictions were the source of the mild fluctuations we had during that time, then theory tells us that’s possible. What puzzles me is why people think the same rule should work now. I don’t think that Calvo type price rigidities are the reason for the problems we are having right now, and hence this does not give us much insight and explanatory power for the Great Recession. Mild price sluggishness is plainly and simply not the dominant friction at work right now, and if that is the case, why would we think the same monetary policy rule should be optimal? If, in fact, there has been a switch in the dominant type of friction affecting the economy — and I would argue there has been — it would be quite remarkable for the same monetary policy rule to be optimal in both situations.

So, I have to agree with Paul Krugman:

Self-contradictory Fed Bashing: David Glasner continues to be unhappy with the Bernanke/QE bashers, this time going after claims that the Fed’s monetary policy was too easy before the crisis.

Much of this discussion is couched in terms of the Taylor Rule, which John Taylor originally suggested — a rule that sets the Fed funds rate based on inflation and either unemployment or some measure of the output gap. This was a clever idea, and has proved useful as a rule of thumb for both description and prediction. But a funny thing happened on the way to the crisis: Taylor and others have elevated this rule to sacred status — and not only that: they have insisted that the original coefficients Taylor suggested, which he basically pulled out of, um, thin air, are sacrosanct.

Surely this is silly. …

Krugman is not making the argument that the nature of the friction has changed and therefore the optimal rule should change as well. That’s my argument so blame me, not him. But the idea that the Taylor rule should have “sacred status” is “silly,” and I don’t understand why Taylor and others insist that the coefficients of the rule — let alone the rule itself — are optimal always and everywhere (there may be a robustness argument — this is the best possible rule in the face of model uncertainty — but that’s not the argument being made).

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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