won’t get fooled again – or will we? monetary policy ... · introduction basic model...

IntroductionBasic Model

Mis-specified IS CurveMis-specified Phillips Curve

“Policy Model Complacency”Conclusions

Won’t Get Fooled Again – Or Will We?Monetary Policy, Model Uncertainty, and ‘Policy

Model Complacency’

Mark Setterfield

New School for Social Research, New York and Trinity College, CT

Money, Finance and the Real Economy; Towards FullEmployment and Inclusive Development, Banco Central de la

Republica Argentina, Buenos Aires, 4-5 June, 2015

Mark Setterfield Won’t Get Fooled Again – Or Will We? Monetary Policy, Model Uncertainty, and ‘Policy Model Complacency’




Introduction

I Question: can modern monetary policy work even if it ispredicated on a mis-specified policy model?

I “modern monetary policy” - interest rate operating procedureI policy “works” if economy moves towards targeted values of

macro variables

I Answer: yes!





Introduction

I Suggests efficacy of monetary policy in the face of policymodel uncertainty

I BUT – purpose not to encourage “policy modelcomplacency”, but to warn against it:

I although policy works, central banks vulnerable to “surprises”– events with systematic origins in the “true model” notanticipated by policy model;

I central bankers should therefore entertain more eclectic viewsof how the economy operates

I pay attention to models outside mainstream model that makenon-mainstream predictions





Introduction

Organization of talk:

I Basic 3-equation model

I Monetary policy with a mis-specified IS curve

I Monetary policy with a mis-specified Phillips curve

I The perils of “policy model complacency”

I Conclusions





Basic 3-equation model – IS curve

I

y = A− δr

r = b + m

⇒ y = A− δ(b + m)





Basic 3-equation model – Phillips curve

I Basic PC:p = ψ + φpe + αy

I Accelerationist PC:φ = 1, pe = p−1, and ψ = −αyn

p = α(y − yn)





Basic 3-equation model – IROP

I Central bank sets overnight rate according to:

b = λ(p − pT ) + µ(y − yT )

I yT = yn if Phillips curve accelerationist





Monetary policy with a mis-specified IS curve

I Suppose that “true model” states:

m = −ηb

I But central bank thinks:

m = m





Monetary policy with a mis-specified IS curve

I “True” IS curve:y = A− δ(1− η)b

I Policy model IS curve:

y = (A + δm)− δb

I Lucas critique problem!





Implications for stability

I Dynamics of economy summarized as:

y = −δ(1− η)[λ(p − pT ) + µ(y − yn)]

p = α(y − yn)

I Equilibrium conditions y = p = 0 yield solutions y = yn andp = pT

I At same time ...






I Tr(J) = −δ(1− η)µ,Det(J) = δ(1− η)λα

I Tr(J) < 0 and Det(J) > 0if η < 1

I Stability plausible (as longas commercial bankreaction to changes inovernight rate not “toolarge”)

J =

[−δ(1− η)µ −δ(1− η)λ

α 0

]





Monetary policy with a mis-specified Phillips curve

I Suppose that “true model” states:

p = ψ + φpe + αy

pe = −(1− k)(p − pT )

I But central bank thinks:

p = α(y − yn)

p = pT





Monetary policy with a mis-specified Phillips curve

I Central bank IROP:

b = µ(y − yT )

I Tinbergen problem!I Central bank thinks p managed by separate policy authority ...I ... so too few instruments relative to policy targets






I Dynamics of economy summarized as:

y = −δµ(y − yT )

p = −φ(1− k)(p − pT )− αδµ(y − yT )

I Equilibrium conditions y = p = 0 yield solutions y = yn andp = pT

I At same time ...






I Tr(J) = −(δµ+ φ[1− k]),Det(J) = δµφ(1− k)

I Tr(J) < 0 and Det(J) > 0if k < 1

I Stability plausible (as longas the expectations remainheterogenous –specifically, some decisionmakers remain credulous(pe = pT ))

J =

[−δµ 0αδµ −φ(1− k)

]





The perils of “policy model complacency”

I Preceding analysis is “good news, bad news” story formonetary policy authorities

I GOOD NEWS obvious:I efficacy of modern monetary policy at least somewhat robust

to policy model mis-specification ...I ... and therefore invulnerable to (at least some) sources of

model uncertainty






I BAD NEWS more subtle because it emanates from the goodnews ...

I ... which can give rise to “policy model complacency”:I policy may succeed even when central bank’s understanding of

the macroeconomy is deficientI danger: success of policy misinterpreted as successful

understanding of underlying workings of economyI result: “policy model complacency”

I creates vulnerability to surprises (events with systematicorigins that are not anticipated by policy model

I as in 2007/08, for example? (See Goodhart 2009, pp.826-7)






I Both examples of policy model mis-specification presentedearlier exemplify vulnerability to surprises emanating from“policy model complacency”

I With mis-specified IS curve, if η becomes “too large” (η > 1– i.e., rate spreads strongly counter-cyclical ), previouslysuccessful monetary policy will suddenly cease to stabilize theeconomy






I With mis-specified Phillips curve, if k becomes “too large”(k = 1 – i.e., pT loses all credibility as anchor for inflationexpectations), previously successful monetary policy willsuddenly cease to stabilize the economy

I Possible to imagine real-world circumstances under whichthese conditions emerge (2007/08 and 1970s, respectively).






I Lessons for policy quite simple: policy makers should entertainmore eclectic views of how the economy functions

I there is no shortage of “heterodox” macro models that differfundamentally from dominant New Consensus DSGE model

I these are provided free of charge by the academyI results of this paper suggest that they amount to a free

insurance policy





Conclusions

I No lack of discontent with economic theory since the crisis

I This includes calls for wholesale abandonment of NewConsensus DSGE model that dominates monetary policyanalysis

I Even if such calls not heeded by policy makers, there is a clearcase for paying more attention to “heterodox” models:

I they are provided at no cost to central banks by academicsI they frequently suggest systematic tendencies that are not

present (or even possible) in DSGE modelsI as such, paying attention to them provides free insurance

against the downside risks inherent in “policy modelcomplacency”


won’t get fooled again – or will we? monetary policy ... · introduction basic model...

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