Edward Nelson

An Optimizing Is-Lm Specification for Monetary Policy and Business Cycle Analysis

This paper asks whether relations of the IS-LM type can sensibly be used for the aggregate demand portion of a dynamic optimizing general equilibrium model intended for analysis of issues regarding monetary policy and cyclical fluctuations. The main result is that only one change -- the addition of a term regarding expected future income -- is needed to make the IS function match a fully optimizing model, whereas no changes are needed for the LM function. This modification imparts a dynamic, forward-looking aspect to saving behavior and leads to a model of aggregate demand that is tractable and usable with a wide variety of aggregate supply specifications. Theoretical applications concerning price level determinacy and inflation persistence are included.

The Future of Monetary Aggregates in Monetary Policy Analysis

This paper considers the role of monetary aggregates in modern macroeconomic models of the New Keynesian type. The focus is on possible developments of these models that are suggested by the monetarist literature, and that in addition seem justified empirically. Both the relation between money and inflation, and between money and aggregate demand, are considered. Regarding the first relation, it is argued that both the mean and the dynamics of inflation in present-day models are governed by money growth. This relationship arises from a conventional aggregate-demand channel; claims that an emphasis on the link between monetary aggregates and inflation requires a direct channel connecting money and inflation, are wide of the mark. The relevance of money for aggregate demand, in turn, lies not via real balance effects (or any other justification for money in the IS equation), but on money’s ability to serve as a proxy for the various substitution effects of monetary policy that exist when many asset prices matter for aggregate demand. This role for monetary aggregates, which is supported by empirical evidence, enhances the value of money to monetary policy.

Timeless Perspective vs. Discretionary Monetary Policy in Forward-Looking Models

This paper reviews the distinction between the timeless perspective and discretionary modes of monetary policymaking, the former representing rule-based policy as recently formalized by Woodford (1999b). In models with forward-looking expectations, this distinction is greater than in the models that have been typical in the rules-vs.-discretion literature; typically there is a second inefficiency from discretionary policymaking, distinct from the familiar inflationary bias. The paper presents calculations of the quantitative magnitude of this second inefficiency, using calibrated models of two types prominent in the current literature. In addition, it examines the distinction between instrument rules and targeting rules; the results indicate that targeting-rule outcomes can be very closely approximated by instrument rules. Also included is a brief investigation of operationality issues, involving the unobservability of current output and the possibility that an incorrect concept of the natural-rate level of output, essential in measuring the output gap, is used by the policymaker. In all of the cases examined, the unconditional average performance of timeless perspective policymaking is at least as good as that provided by optimal discretionary behavior.

Direct Effects of Base Money on Aggregate Demand: Theory and Evidence

Meltzer (1999a) shows that real monetary base growth is a significant determinant of consumption growth in the United States, controlling for the short-term real interest rate. In this paper, I show that the same property of base money holds for total output (relative to trend or potential) in both the United States and the United Kingdom. The standard optimising IS-LM model cannot account for this result, but I show that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky.

Optimal Horizons for Inflation Targeting

In this paper we investigate the problem of selecting an optimal horizon for inflation targeting in the United Kingdom. Since there are two key ways of thinking about an optimal horizon, we look at optimal horizons for both of these interpretations. In addition, to see whether our results are robust in the face of model uncertainty, we compute optimal horizons for two different models with divergent structural and dynamic characteristics.

Inflation Dynamics, Marginal Cost, and the Output Gap: Evidence from Three Countries

Recent studies have argued that the New Keynesian Phillips curve (Calvo pricing model) is empirically valid, provided that real marginal cost rather than detrended output is used as the variable driving inflation. One interpretation of this result is that real marginal cost is not closely related to the output gap, and so models for monetary policy need to include labormarket rigidities. An alternative interpretation is that marginal cost and the output gap are closely related, but that the latter needs to be measured in a manner consistent with dynamic general equilibrium models. To date, there has been little econometric investigation of this alternative interpretation. This paper provides estimates of the New Keynesian Phillips curve for the U.S., the U.K., and Australia using theory-consistent estimates of the output gap. Using this theory to measure the output gap leads to a considerable improvement in the empirical performance of output-gapbased Phillips curves.

UK Monetary Policy 1972-97: A Guide Using Taylor Rules

In the period from the floating of the exchange rate in 1972 to the granting of independence to the Bank of England in 1997, UK monetary policy went through several regimes, including: the early 1970s, when monetary policy was subordinate to incomes policy as the primary weapon against inflation; Sterling M3 targeting in the late 1970s and early 1980s; moves in the late 1980s toward greater exchange rate management, culminating in the UK’s membership of the ERM from 1990-92; and inflation targeting from October 1992. This Paper estimates simple interest rate reaction functions, or ‘Taylor rules’, for different UK monetary policy regimes. The inflation targeting regime that began in 1992 appears to be the only period that is characterized by the ‘Taylor principle’, namely a greater than one-for-one response of interest rates to fluctuations in inflation. In contrast to the US case, the early 1980s disinflation in the UK appears best characterized as an increase in the intercept of the authorities’ interest rate rule rather than by an increased systematic response of monetary policy to inflation.

The Federal Reserve's Large‐Scale Asset Purchase Programmes: Rationale and Effects

We provide empirical estimates of the effect of large‐scale asset purchases (LSAPs) on longer term US Treasury yields within a framework that allows for several transmission channels including the scarcity channel associated with the preferred‐habitat literature and the duration channel associated with interest‐rate risk. We also clarify LSAPs’ role in the broader context of historical monetary policy strategy. Results indicate that LSAP‐style operations mainly impact longer term rates via the nominal term premium; within that premium, the response is predominantly embodied in the real term premium. The scarcity and duration channels both seem to be of considerable importance.

The Lag from Monetary Policy Actions to Inflation: Friedman Revisited

This paper updates and extends Friedman’s (1972) evidence on the lag between monetary policy actions and the response of inflation. Our evidence is based on UK and US data for the period 1953–2001 on money growth rates, inflation, and interest rates, as well as annual data on money growth and inflation. We reaffirm Friedman’s result that it takes over a year before monetary policy actions have their peak effect on inflation. This result has persisted despite numerous changes in monetary policy arrangements in both countries. Similarly, advances in information processing and in financial market sophistication do not appear to have substantially shortened the lag. The empirical evaluation of dynamic general equilibrium models needs to be extended to include an assessment of these models’ ability to account for the monetary transmission lags found in the data.

Sluggish inflation and optimizing models of the business cycle

Abstract Many researchers have added sticky prices to quantitative business cycle models. I simulate several of these models in order to evaluate their success at reproducing two features of US data: the lagged reaction of inflation to monetary growth, and the persistence of inflation.