Marc P. Giannoni

DOES MODEL UNCERTAINTY JUSTIFY CAUTION? ROBUST OPTIMAL MONETARY POLICY IN A FORWARD-LOOKING MODEL

This paper proposes a general method based on a property of zero-sum two-player games to derive robust optimal monetary policy rules—the best rules among those that yield an acceptable performance in a specified range of models—when the true model is unknown and model uncertainty is viewed as uncertainty about parameters of the structural model. The method is applied to characterize robust optimal Taylor rules in a simple forward-looking macroeconomic model that can be derived from first principles. Although it is commonly believed that monetary policy should be less responsive when there is parameter uncertainty, we show that robust optimal Taylor rules prescribe in general a stronger response of the interest rate to fluctuations in inflation and the output gap than is the case in the absence of uncertainty. Thus model uncertainty does not necessarily justify a relatively small response of actual monetary policy.

DSGE Models in a Data-Rich Environment

Standard practice for the estimation of dynamic stochastic general equilibrium (DSGE) models maintains the assumption that economic variables are properly measured by a single indicator, and that all relevant information for the estimation is adequately summarized by a small number of data series, whether or not measurement error is allowed for. However, recent empirical research on factor models has shown that information contained in large data sets is relevant for the evolution of important macroeconomic series. This suggests that conventional model estimates and inference based on estimated DSGE models are likely to be distorted. In this paper, we propose an empirical framework for the estimation of DSGE models that exploits the relevant information from a data-rich environment. This framework provides an interpretation of all information contained in a large data set through the lenses of a DSGE model. The estimation involves Bayesian Markov-Chain Monte-Carlo (MCMC) methods extended so that the estimates can, in some cases, inherit the properties of classical maximum likelihood estimation. We apply this estimation approach to a state-of-the-art DSGE monetary model. Treating theoretical concepts of the model --- such as output, inflation and employment --- as partially observed, we show that the information from a large set of macroeconomic indicators is important for accurate estimation of the model. It also allows us to improve the forecasts of important economic variables

Has Monetary Policy Become Less Powerful

Recent vector autoregression (VAR) studies have shown that monetary policy shocks have had a reduced effect on the economy since the beginning of the 1980s. This paper investigates the causes of this change. First, we estimate an identified VAR over the pre- and post-1980 periods, and corroborate the existing results suggesting a stronger systematic response of monetary policy to the economy in the later period. Second, we present and estimate a fully specified model that replicates well the dynamic response of output, inflation, and the federal funds rate to monetary policy shocks in both periods. Using the estimated structural model, we perform counterfactual experiments to quantify the relative importance of changes in monetary policy and changes in the private sector in explaining the reduced effect of monetary policy shocks. The main finding is that changes in the systematic elements of monetary policy are consistent with a more stabilizing monetary policy in the post-1980 period and largely account for the reduced effect of unexpected exogenous interest rate shocks. Consequently, there is little evidence that monetary policy has become less powerful.

How Forward-Looking is Optimal Monetary Policy?

We calculate optimal monetary policy rules for several variants of a simple optimizing model of the monetary transmission mechanism with sticky prices and/or wages. We show that robustly optimal rules can be represented by interest-rate feedback rules that generalize the celebrated proposal of Taylor (1993). Optimal rules, however, require that the current interest rate operating target depend positively on the recent past level of the operating target, and its recent rate of increase, in a way that is characteristic of estimated central bank reaction functions, but not of Taylors proposal. We furthermore find that a robustly optimal policy rule is almost inevitably an implicit rule that requires the central bank to use a structural model to project the economys evolution under the contemplated policy action. However, calibrated examples suggest that optimal rules place less weight on projections of inflation or output many quarters in the future than do rules often discussed in the literature on inflation targeting, or in the current practice of inflation-forecast targeting central banks.

How Has the Euro Changed the Monetary Transmission Mechanism

On January 1, 1999, the euro officially became the common currency for 11 countries of continental Europe, and a single monetary policy started under the authority of the European Central Bank (ECB). The European Monetary Union (EMU) followed decades of monetary policies set by national central banks to serve domestic interests, even though these national policies were constrained by monetary arrangements such as the European Monetary System (EMS), which was designed to limit exchange rate fluctuations. Approaching the tenth anniversary of the EMU, we begin to have sufficient data to potentially observe effects of the monetary union on business cycle dynamics. This paper has three objectives. The first is to characterize the transmission mechanism of monetary policy in the euro area (EA) and across its constituent countries. The second is to document how this transmission might have changed since the creation of the euro. The third objective consists of providing a set of explanations, based on a structural open‐economy model, for the observed differences over time and across countries in the responses of key macroeconomic variables. Our first twoobjectives require an empiricalmodel that captures empirically the EA‐wide macroeconomic dynamics, while allowing us to estimate the potentially heterogeneous transmission of EA shocks within individual countries. The factor‐augmented vector autogression (FAVAR) model proposed by Bernanke, Boivin, and Eliasz (2005) is a natural framework in this context. By pooling together a large set of macroeconomic indicators from individual countries, it allows us to identify areawide factors, quantify their importance in the country‐level fluctuations, and trace out the effect of identified aggregate shocks on all country‐level

Optimal interest-rate rules and inflation stabilization versus price-level stabilization

This paper compares the properties of interest-rate rules such as simple Taylor rules and rules that respond to price-level fluctuations (called Wicksellian rules) in a basic forward-looking model. By introducing appropriate history dependence in policy, Wicksellian rules perform better than optimal Taylor rules in terms of welfare, robustness to alternative shock processes, and are less prone to equilibrium indeterminacy. A simple Wicksellian rule augmented with a high degree of interest rate inertia resembles a robustly optimal rule, i.e., a monetary policy rule that implements the optimal plan and that is also completely robust to the specification of exogenous shock processes.

The FRBNY DSGE Model

The goal of this paper is to present the dynamic stochastic general equilibrium (DSGE) model developed and used at the Federal Reserve Bank of New York. The paper describes how the model works, how it is estimated, how it rationalizes past history, including the Great Recession, and how it is used for forecasting and policy analysis.

Safety, Liquidity, and the Natural Rate of Interest

Why are interest rates so low in the Unites States? We find that they are low primarily because the premium for safety and liquidity has increased since the late 1990s, and to a lesser extent because economic growth has slowed. We reach this conclusion using two complementary perspectives: a flexible time series model of trends in Treasury and corporate yields, inflation, and long-term survey expectations; and a medium-scale dynamic stochastic general equilibrium model. We discuss the implications of this finding for the natural rate of interest.

Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge

Under rational expectations, monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure: Anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets. In this environment, the expectations hypothesis of the yield curve need not hold, a situation called unanchored financial market expectations. Whether or not financial market expectations are anchored, the private sector’s imperfect knowledge mitigates the efficacy of optimal monetary policy. Under anchored expectations, slow adjustment of interest rate beliefs limits scope to adjust current interest rate policy in response to evolving macroeconomic conditions. Imperfect knowledge represents an additional distortion confronting policy, leading to greater inflation and output volatility relative to rational expectations. Under unanchored expectations, current interest rate policy is divorced from interest rate expectations. This permits aggressive adjustment in current interest rate policy to stabilize inflation and output. However, unanchored expectations are shown to raise significantly the probability of encountering the zero lower bound constraint on nominal interest rates. The longer the average maturity structure of the public debt, the more severe is the constraint.

The Inflation Output Trade-Off Revisited

A rich literature from the 1970s shows that as inflation expectations become more and more ingrained, monetary policy loses its stimulative effect. In the extreme, with perfectly anticipated inflation, there is no trade-off between inflation and output. A recent literature on the interest-rate zero lower bound, however, suggests there may be some benefits from anticipated inflation when the economy is in a liquidity trap. In this paper, we reconcile these two views by showing that while it is true that, at positive interest rates, the greater the anticipated inflation the less stimulative are the effects, the opposite holds true at the zero bound. Indeed, at the zero bound, the more the public anticipates inflation, the greater is the expansionary effect of inflation on output. This leads us to revisit the trade-off between inflation and output and to show how radically it changes in the face of demand shocks large enough to bring the economy into a liquidity trap. Instead of vanishing once inflation becomes anticipated, the trade-off between inflation and output increases substantially and may become arbitrarily large. In such cases, raising the inflation target in a liquidity trap can be very stimulative.