Benjamin M. Friedman

Optimal expectations and the extreme information assumptions of ‘rational expectations’ macromodels

Abstract ‘One might reply that the rationality of a persons choice does not depend upon how much he knows, but only upon how well he reasons from whatever information he has, however incomplete. Our decision is perfectly rational provided that we face up to our circumstances and do the best we can.’ (John Rawls, A Theory of Justice )

A price target for U.S. monetary policy? Lessons from the experience with money growth targets

The cutting edge of recent efforts to reshape monetary policy in many countries has been to impose a price target on the central bank. This paper examines such a policy in light of the Federal Reserve Systems experience with money targeting from the late 1970s through the mid 1980s. The empirical analysis documents the Federal Reserves initial use and subsequent disregard of money growth targets, and shows that abandoning these targets was a sensible response to the changing mix of shocks affecting the U.S. economy -- specifically, an increase in the relative volatility of money demand shocks. This experience provides little ground for confidence that a price target would be optimal for U.S. monetary policy. Even if the structure of the relevant shocks at any particular time were to appear favorable, a policy based on a price target would likewise be undermined if the relative volatility of aggregate supply shocks increased.

Economic Implications of Extraordinary Movements in Stock Prices

MOST PEOPLE AGREE that stock prices sometimes behave in strange ways. Going beyond this simple observation typically proves more difficult. For at least the past quarter century, economists have been well aware that the variation of stock prices does not nicely match the familiar bell-shaped normal distribution.1 The problem is too many extreme movements. Very large increases or decreases would always be possible even if changes in stock prices were normally distributed, but they would occur only rarely. By contrast, actual stock prices rise or fall by large percentage amounts fairly often-certainly often enough to raise serious doubts that the usual normal distribution provides a useful way to think about how they vary. Economists and other analysts of the stock market have tended to react to this problem in either of two ways. The most common approach is simply to ignore it and go ahead to analyze changes in stock prices as

Targets and Instruments of Monetary Policy

Publisher Summary This chapter discusses the major conceptual developments in the literature of targets and instruments of money policy, with particular emphasis on the broader strategic issues defining the overall framework within which policy operates. The instrument problem of the selection of specific price or quantity that the central bank directly and immediately controls is examined in the chapter. It is a fact that what most people mean by money in discussions of monetary policy is not a plausible policy instrument at all, because it is endogenous in the kind of fractional reserve banking system common to most modern market economies. Hence, money is at best an intermediate target of monetary policy. The chapter discusses the implications of alternative monetary policy frameworks for the information available to the economys private sector, the positive empirical question of when and whether any given central bank has actually based its operations on one kind of targeting strategy or another, and the empirical basis for making the normative selections of monetary policy targets and instruments.

Another look at the evidence on money-income causality

Abstract Stock and Watsons widely noted finding that money has statistically significant marginal predictive power with respect to real output (as measured by industrial production), even in a sample extending through 1985 and even in the presence of a short-term interest rate, is not robust to two plausible changes. First, extending the sample through 1990 renders money insignificant within Stock and Watsons chosen specification. Second, using the commercial paper rate in place of the Treasury bill rate renders money insignificant even in the sample ending in 1985. A positive finding is that the difference between the commercial paper rate and the Treasury bill rate does have highly significant predictive value for real output, even in the presence of money, regardless of sample. Alternative results, based on forecast error variance decomposition in a vector autoregression setting, confirm these findings by indicating a small and generally insignificant effect of money and a large and highly significant effect of the paper-bill spread on real output.

The Inefficiency of Short-Run Monetary Targets for Monetary Policy

THE ADOPTION of short-run monetary targets has been the most significant development in the practice of central banking during the 1970s, at least in the context of domestic monetary policy. The central banks of most of the industrialized Western economies now use explicit targets for monetary growth in formulating and implementing monetary policy. In the United States the Federal Reserve System moved informally to a greater emphasis on the monetary aggregates in early 1970; and since 1975 the Congress, under House Concurrent Resolution 133, has required the Chairman of the Federal Reserve Board to report formally each quarter the specific monetary-growth targets chosen by the Federal Open Market Committee as the near-term objective of monetary policy. Private economic analysts in turn have come to focus on such announcements, and comparing each Thursdays new money statistics against the corresponding target values is now the economic highlight of the week in the financial markets. In short, the era of monetary policy by monetary targets has arrived. For the most part, both academic economists and the business community have welcomed this development. During the mid-1960s a number

Economic Implications of Changing Share Ownership

Institutional investors, including especially pension funds and mutual funds, are steadily replacing individuals as owners of equity shares in the United States. Forty years ago individual investors owned 90% of all equity shares outstanding. Today the individually owned share is just 50%. The arguments and evidence surveyed in this paper suggest four ways in which this shift in share ownership could affect the functioning of the equity market: (1) Increasing institutional ownership could either enhance or impair the markets ability to provide equity financing for emerging growth companies. (2) Increasing institutional ownership, especially in the form of open-end mutual funds, has probably increased the markets volatility in the context of occasional large price movements. (3) The increasing prevalence of defined contribution (as opposed to defined benefit) pension plans, and especially of 401-k plans, has probably resulted in an increased market price of risk. (4) Increasing institutional ownership has facilitated a greater role for shareholders in the governance of U.S. corporate business, and correspondingly reduced the independence of corporate managements.

The Greenspan Era: Discretion, Rather than Rules

What stands out in retrospect about U.S. monetary policy during the Greenspan Era is the ongoing movement away from mechanistic restrictions on the conduct of policy, together with a willingness on occasion to depart even from what more flexible guidelines dictated by contemporary conventional wisdom would imply, in the interest of carrying out the Federal Reserve System%u2019s dual mandate to pursue both stable prices and maximum employment. Part of this change was procedural %u2013 for example, the elimination of money growth targets. The most substantive demonstration of policy flexibility came in the latter half of the 1990s, as unemployment fell below 6% (in 1994), then below 5% (in 1997), and then remained below 5% for more than four years, yet the Federal Reserve did not tighten monetary policy. This policy stance was consistent with a view of the economy, including faster productivity growth and increased exposure to international competition, that Chairman Greenspan had articulated nearly a decade before.

Interest Rate Uncertainty and the Value of Bond Call Protection

This paper uses a model of the valuation of bonds bearing call options, together with observed market yields on callable bonds, to infer information about the uncertainty associated with interest rate expectations. A dynamic programming solution of the model simultaneously determines both the bond price and the issuers optimal refunding strategy, given the relevant data describing the bond and the markets expectations of future interest rates. Application of the valuation model in reverse, for quarterly average data for 1969-76, generates a time series representing the uncertainty which the market associated with its expectations of future interest rates during this interval, given the then-prevailing yields on new issues of utility bonds and industrial bonds callable after 5 years and 10 years, respectively. This uncertainty, parameterized as the standard deviation of a truncated normal distribution, fluctuated between 1/2 percent and 3/4 percent between 1969 and early 1974, then rose to sharply higher levels from mid-1974 through mid-1975, and has fluctuated between 3/4 percent and 1 percent since late 1975.

Aspects of Investor Behavior Under Risk

The three sections of this paper support three related conclusions. First, asset demands with the familiar properties of wealth homogeneity and linearity in expected returns follow as close approximations from expected utility maximizing behavior under the assumptions of constant relative risk aversion and joint normally distributed asset returns. Second, although such asset demands exhibit a symmetric coefficient matrix with respect to the relevant vector of expected asset returns, symmetry is not a general property, and the available empirical evidence warrants rejecting it for both institutional and individual investors in the United States. Finally, in a manner analogous to the finite maximum exhibited by quadratic utility, a broad class of mean-variance utility functions also exhibits a form of wealth satiation which necessarily restricts it range of applicability.