Journal of Economic Perspectives | Macro Paper Warehouse

Inflation Targeting: A New Framework for Monetary Policy?

This 1997 Journal of Economic Perspectives essay by Ben Bernanke and Frederic Mishkin is a survey and policy assessment, not an empirical study: it draws on comparative experience across the eight economies that had formally adopted inflation targeting by 1997 (Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom), on Germany and Switzerland as “hybrid” cases that pursue inflation goals through money-growth targets, and on existing empirical work, to assess inflation targeting (IT) as a framework for monetary policy. All eight direct targeters use CPI-based series (often “core” or “underlying” measures excluding food, energy, indirect taxes, or mortgage costs), set target levels at 4 percent or below, mostly as ranges rather than points, over horizons of one to four years, and retain short-run flexibility through supply-shock exclusions, target ranges, adjustable near-term targets, or explicit escape clauses. The paper’s central argument is that IT is best understood as “constrained discretion” — a third category distinct from both a mechanical policy rule and pure discretion, since it fixes the medium-term goal while leaving short-run tactics to the central bank’s judgment — and that it serves two functions: providing a nominal anchor that reduces uncertainty about future inflation, and creating transparency and accountability that can discipline policymakers against inflationary bias. The authors argue against treating IT as an exclusive single-goal rule, note that there is not yet evidence that IT countries have disinflated at lower sacrifice ratios than others or that announcing targets by itself moves private expectations, favor a positive target of roughly 2 percent over a zero target (citing CPI measurement bias of an estimated 0.5 to 2 percentage points per year, downward nominal-wage rigidity, and insurance against deflation), and express a mild preference for inflation targeting over nominal GDP targeting on grounds of data timeliness, the practical similarity in short-run flexibility, and public understandability, while arguing the pre-1997 Volcker-Greenspan Federal Reserve’s policymaking framework was already “de facto very similar to inflation targeting.”

Inside the Black Box: The Credit Channel of Monetary Policy Transmission

This 1995 Journal of Economic Perspectives paper by Ben Bernanke and Mark Gertler surveys the “credit channel” of monetary policy transmission — described explicitly as an amplifying mechanism, not an independent channel — under which monetary tightening raises the external finance premium (the wedge between the cost of external and internal funds) on top of its direct effect on market interest rates, thereby explaining three empirical puzzles that conventional interest-rate theory leaves unresolved: the large real effects of small interest-rate movements, the delayed timing of investment and inventory responses relative to the largely transitory rise in rates, and the unexpectedly large and rapid response of residential investment relative to business structures. Using a monthly four-variable recursive VAR (1965-1993), the authors document that after a monetary tightening, real GDP begins declining about four months later and bottoms out around two years out, even though the federal funds rate itself is back near trend within 9-12 months; inventory disinvestment accounts for a substantial part of the initial output decline, and business fixed investment (concentrated in equipment, not structures) responds with the longest lag of all spending components. The paper attributes these facts to two credit-channel mechanisms — a balance sheet (net worth) channel, under which rising rates and falling asset prices directly and cumulatively weaken borrowers’ balance sheets (evidenced by a coverage ratio that tracks the funds rate closely and by roughly 40% of the short-run profit decline coming from higher interest payments), and a bank lending channel, under which reserve drains restrict loan supply to bank-dependent borrowers (evidenced by widening CD-Treasury bill spreads during tight-money periods) — while candidly noting the two mechanisms cannot be cleanly separated empirically and that the bank lending channel has likely weakened since financial deregulation.

Microeconomic Heterogeneity and Macroeconomic Shocks

This essay analyzes the role of household heterogeneity for how the macroeconomy responds to aggregate shocks. After reviewing how quantitative macroeconomics incorporated household heterogeneity and market incompleteness over roughly three decades – work that, the authors argue, has been mostly confined to inequality and redistribution questions rather than business cycles, partly because of computational complexity and partly because of a widespread but “inaccurate” reading of Krusell and Smith’s (1998) “approximate aggregation” result as showing heterogeneous- and representative-agent dynamics are essentially the same – the paper outlines an emerging Heterogeneous Agent New Keynesian (HANK) framework, built on Kaplan, Moll, and Violante (2018), that gives households access to both a low-return liquid asset and a high-return illiquid asset subject to a transaction cost. Simulating a consistently calibrated HANK model against its representative-agent (RANK) counterpart, the authors introduce a three-way taxonomy of “strong,” “weak,” and “non-equivalence” between the two frameworks and show, through a discount-factor (demand) shock, a total-factor-productivity shock, a monetary policy shock, and government spending and transfer shocks, that the degree of equivalence depends entirely on which shock is analyzed: demand shocks are strongly equivalent, TFP shocks produce similar aggregate paths through different mechanisms, and monetary and fiscal shocks generate starkly different aggregate responses because HANK consumption is far more sensitive to current disposable income and far less sensitive to interest-rate changes than RANK consumption. The paper’s second message is that heterogeneous-agent models open up macroeconomic questions that representative-agent models cannot even pose – microfounding a fall in aggregate demand through tighter credit limits or higher idiosyncratic income risk, using the cross-sectional pattern of a shock’s transmission to help identify its source, and studying how aggregate shocks and stabilization policy reshape household inequality – and it closes by naming seven directions (real wage and product-market frictions, labor-market microfoundations, gross and nominal balance sheets, time-varying risk premia, financial intermediaries, non-rational-expectations, and optimal policy) along which the still-“infant” HANK framework needs further development.

Monetary Policy Lessons of Recent Inflation and Disinflation

This 1988 Journal of Economic Perspectives paper by William Poole is a survey and analytical essay – not a structural estimation exercise with a formal identification strategy – that draws lessons from the U.S. inflation and disinflation experience of roughly 1975 to 1987 for money demand, real interest rate behavior, market expectations of monetary policy, and the design of monetary rules. Its central empirical exhibit is the breakdown of the “standard” M1 demand function: a specification with income elasticity near 1.0 and interest elasticity of only about 0.15 to 0.25 (citing Goldfeld 1973) had appeared consistent with a roughly 3 percent per year secular rise in M1 velocity from 1953:1 through 1979:4, but velocity departed sharply and unpredictably from that trend after 1981. Poole argues the conventionally low interest elasticity is itself an artifact of estimating money demand in first-difference form: annual first-difference regressions of the change in log(M1 velocity) on the change in log(Aaa bond yield) over several sub-periods between 1916 and 1986 (Table 2) yield coefficients of only about 0.07 to 0.28 (and the wrong sign, -0.16, for 1919-1946), because a constant term in a first-difference regression is mathematically equivalent to a linear time trend in levels and so absorbs the velocity trend that the trending interest rate should instead be explaining, and because short-run money-demand “disturbances” are in fact correlated with credit-market and income disturbances (a “buffer stock” mechanism) rather than statistically independent as the standard specification assumes. Re-estimating in levels, with income elasticity constrained to 1.0 and using sample periods chosen so the interest rate is approximately the same at both endpoints to limit trend-attribution bias (1915-1964 and 1920-1968), Poole obtains – and explicitly calls “tentative” – an interest elasticity of about 0.6 in absolute value (Table 3), two to four times the first-difference estimates, with the long-term Aaa bond yield fitting consistently better than the commercial paper rate (coefficients of roughly 0.65-0.67 versus 0.19-0.33, with higher R-squared throughout), which he attributes to agents responding to permanent rather than transitory changes in the opportunity cost of holding money. On real interest rates, Poole notes they rose from roughly 1-2 percent (1953-73) and 0 to -2 percent (1973-78) into a 4-8 percent range in 1980-85, and argues that while the severity of the 1981-82 recession (peak unemployment near 11 percent) is qualitatively consistent with a monetary explanation, the vigorous 1983-84 recovery is not; for 1983-85 specifically he judges the joint behavior of the real exchange rate (the dollar appreciated more than 60 percent from its 1980 average to its February 1985 peak), the real economy, and the real interest rate “simply not consistent with a monetary explanation,” pointing instead to the 1981 U.S. tax-law change as his preferred real disturbance while explicitly declining to rule out competing explanations (e.g., the federal budget deficit) or offer a clean decomposition. On market expectations, drawing on published estimates from Roley and Troll (1983) and Roley (1986), Poole reports that the Treasury bill rate’s response to an unexpected $1 billion weekly M1 surprise rose from a “trivial” 1.6 basis points under the Federal Reserve’s October 1977-October 1979 interest-rate-control procedure to 10.4 basis points under its October 1979-October 1982 nonborrowed-reserves targeting procedure, before falling to 3.4 and then 1.4 basis points as the Fed reverted toward interest-rate control – evidence, in Poole’s reading, that the informativeness of money-stock announcements to markets is endogenous to the Fed’s own operating procedure rather than a fixed structural parameter. Poole concludes that the steady-state case for a monetary rule of constant money growth is essentially unaffected by this experience, but that the competing “gradualist” prescription – a pre-announced, stepwise reduction in money growth to engineer disinflation – is “unreliable,” since the 1981-1986 velocity decline was far larger than any conventional model would have predicted and, by his own explicitly “very casual” counterfactual reasoning, a gradualist money-growth path begun in 1980 would likely have produced deflation rather than the disinflation actually achieved.

On DSGE Models

This 2018 Journal of Economic Perspectives essay by Lawrence Christiano, Martin Eichenbaum, and Mathias Trabandt is a perspective/survey defense of dynamic stochastic general equilibrium (DSGE) modeling rather than an empirical study: it traces how the DSGE research program evolved from real business cycle (RBC) models through New Keynesian DSGE to post-crisis models with financial frictions, argues that the transparency of these models’ microfoundations is a virtue because it exposes suspicious assumptions to scrutiny against micro data, explains why the pre-crisis vintage of these models failed to predict the 2008 financial crisis, and closes with a point-by-point rebuttal of Joseph Stiglitz’s (2017) critique of the DSGE program. The authors argue RBC models (Kydland-Prescott 1982; Long-Plosser 1983) “crumbled” under three forces – micro evidence against frictionless labor markets, failure to match aggregate facts such as hours volatility and the equity premium, and the absence of any role for money – and that the New Keynesian DSGE models that followed can reproduce the hump-shaped consumption, investment, and output responses to a monetary policy shock (estimated under recursive/Cholesky identification on US data, 1951Q1-2008Q4, a pattern the authors report as robust across lag lengths of one to five quarters and multiple sample start dates) only by combining habit formation in consumption, investment adjustment costs, and Calvo (1983) nominal price/wage rigidities with features that keep marginal cost nearly acyclical. In the Christiano-Eichenbaum-Trabandt (2016) Bayesian re-estimation of the Christiano-Eichenbaum-Evans (2005) model that the essay treats as its illustrative case, the posterior mode implies firms reprice roughly once every 2.3 quarters, households reset wages about once a year, the habit-formation coefficient is 0.75, and the elasticity of investment to a one percent temporary rise in the price of installed capital is 0.16, with the fit to the hump-shaped facts depending critically on sticky nominal wages – a flexible-wage counterfactual “deteriorates drastically.” On the crisis, the authors concede that DSGE models’ failure to signal the buildup of shadow-banking vulnerability “is correct” as a criticism, but frame it as a failure of the broader economics profession rather than something specific to DSGE, and defend the relative absence of large financial frictions in pre-crisis models by noting that postwar US recessions were not historically tied to financial disturbances and that the financial accelerator mechanism (Bernanke-Gertler-Gilchrist 1999) that some models did include had only “a modest quantitative effect” on estimated dynamics. The essay then surveys post-crisis extensions – rollover-crisis and fire-sale models of financial intermediaries (Gertler-Kiyotaki), risk-shock models in which time-varying cross-sectional dispersion of firm returns (Christiano-Motto-Rostagno 2014) is reported to account for about 60 percent of the variance of US business cycles versus roughly 13 percent for technology shocks, zero-lower-bound (ZLB) and nonlinear models attributing much of the Great Recession to financial frictions interacting with a binding ZLB, a government-spending multiplier the authors describe as “much larger than one” at the ZLB and “substantially below one” away from it, the “forward guidance puzzle” (standard models make forward guidance implausibly powerful), and heterogeneous-agent (HANK) models – before rebutting Stiglitz (2017) on four specific fronts: that modern DSGE estimation does not rely on HP-filtered data, that pre-crisis DSGE models did incorporate financial frictions, that interest-rate spreads do appear as central endogenous variables in some models, and that household heterogeneity is an active DSGE research frontier (HANK). The authors judge Stiglitz’s criticisms “not informed” while explicitly acknowledging that DSGE models will not reliably predict the next crisis and that the modeling program is “an organic process” of ongoing interaction between data and theory.

Symposium on the Monetary Transmission Mechanism

This 1995 Journal of Economic Perspectives paper by Frederic Mishkin is the introduction to a JEP symposium on the monetary transmission mechanism, and it contains no original data or estimation of its own; instead it lays out an organizing taxonomy of the channels through which monetary policy affects real activity, against which the symposium’s other papers (Taylor 1995, Bernanke and Gertler 1995, Obstfeld and Rogoff 1995, and Meltzer 1995) are meant to be read. Mishkin groups the transmission channels into four broad categories. The traditional Keynesian interest-rate channel runs from a monetary contraction to higher real interest rates (via sticky prices and rational expectations) to a higher cost of capital to lower business fixed investment, residential investment, consumer durables spending, and inventory investment; Mishkin notes this channel is contested within the symposium, since Taylor argues for a strong interest-rate effect while Bernanke and Gertler counter that “empirical studies have had great difficulty in identifying quantitatively important effects of interest rates through the cost of capital,” a difficulty that itself motivated the search for credit-channel alternatives. The exchange-rate channel extends the interest-rate logic to an open economy: higher domestic real rates make domestic-currency deposits relatively more attractive, appreciating the currency and reducing net exports and output. A third category, other asset-price effects, covers Tobin’s q (a monetary contraction lowers equity prices, reducing the market value of firms relative to the replacement cost of capital and so discouraging investment financed by new equity issuance) and Modigliani life-cycle wealth effects (a fall in equity and other asset values lowers households’ lifetime resources and hence consumption), with Meltzer’s symposium contribution extending this logic to land and property values via the Japanese experience of the 1980s-1990s. The fourth category, the credit channel, is the paper’s most detailed, comprising a bank lending channel (a monetary contraction drains bank reserves and deposits, cutting the supply of loans to bank-dependent borrowers such as small firms facing asymmetric-information constraints in public capital markets, though Mishkin notes doubts about this channel’s continued quantitative importance given financial innovation’s erosion of banks’ relative role since the 1950s-1970s); a balance-sheet channel operating through equity prices and net worth (lower net worth raises adverse selection and moral hazard in both business lending and consumer credit for durables and housing); a balance-sheet channel operating through cash flow (higher interest rates directly reduce firm cash flow and so weaken balance sheets independent of equity-price movements); an unanticipated-price-level or debt-deflation channel (an unexpected price decline raises the real value of nominally fixed debt, a rationalization of Fisher’s 1933 debt-deflation account of the Great Depression); and a liquidity effects channel operating through consumers’ own willingness to spend rather than lenders’ willingness to lend (a decline in financial asset values raises the perceived likelihood of financial distress, and because consumer durables and housing are illiquid assets subject to an Akerlof-style “lemons” discount in a distress sale, consumers shift toward more liquid financial assets and cut durables and housing spending). No empirical magnitudes are presented in Mishkin’s own text — the paper’s magnitudes and evidence come from the symposium papers it introduces (Taylor 1995, Bernanke and Gertler 1995, and others) — and Mishkin’s meta-argument, developed in the introduction and concluding remarks, is that monetary policy operates through several of these channels simultaneously, so that focusing solely on the textbook interest-rate channel risks missing quantitatively important transmission routes running through credit markets and asset prices.

The Monetary Transmission Mechanism: An Empirical Framework

This 1995 Journal of Economic Perspectives paper by John B. Taylor lays out an empirical framework for the monetary transmission mechanism and asks what it implies for the choice between fixed and flexible exchange rates and for the design of a monetary policy rule. Rather than identifying shocks in a VAR, Taylor synthesizes his own multicountry structural model (Taylor 1993a) – a rational-expectations model with staggered wage and price setting, estimated for the US, Canada, Germany, France, Japan, Italy, and the UK – together with corroborating reduced-form evidence from Romer and Romer (1994). The framework centers on a five-link causal circle: a change in the short-term interest rate moves the exchange rate through uncovered interest rate parity, and that real exchange rate change affects net exports and GDP; the short rate also moves the long-term rate through an expectations model of the term structure, and that real long rate affects consumption and investment (including all three components of fixed investment – business equipment, business structures, and residential – which are significantly negatively related to the real interest rate in the US, and negatively related to the real interest rate in every G-7 country); GDP and inflation then feed back into the short rate through the policy reaction function, closing the loop. Taylor argues financial-market prices – the short rate, the exchange rate, and the long rate – are the right objects of analysis because money demand for M1 and M2 “seems to have shifted substantially in recent years” and credit-flow measures are “at least as unreliable,” while uncovered interest rate parity is said to describe the “larger and longer swings” in interest rate differentials and the dollar reasonably well even though high-frequency deviations remain unexplained. Comparing model elasticities estimated over an early-1970s-to-mid-1980s sample against an early-1970s-to-mid-1990s sample, Taylor reports that the real GDP response to a 3 percent unanticipated permanent increase in the target price level (a proxy for an easing) fell in all three countries examined in detail – the US, Germany, and Japan – with the decline larger in the US than in the other two; within the US the interest elasticity of investment fell while that of consumption rose, though “there is no general pattern” across the G-7. Simulations of exchange rate arrangements among the US, Japan, and Europe show flexible rates producing lower variability of both real GDP and inflation than fixed rates, and Taylor notes that his own 1993 interest-rate rule – weighting the inflation deviation and output gap equally at 0.5 – “has turned out to describe recent Federal Reserve policy very accurately.” He also states that bond-supply effects on the term structure, while sometimes detected, are “too small to explain the errors in the term structure equations on a systematic basis.” Throughout, the underlying elasticities and simulation results are drawn from the companion structural model (Taylor 1993a) rather than estimated afresh in this paper, and Taylor flags the framework’s own weak points: the short rate is “only one of many factors” affecting the exchange rate and long rate, uncovered interest rate parity’s high-frequency failures remain unexplained, and the choice of a single long-term real rate to represent the cost of capital is an acknowledged simplification.

The Triumph of Monetarism?

This essay traces the 20th-century arc of “monetarism,” from Irving Fisher’s original turn-of-the-century quantity theory through the discipline’s late-1990s split between “New Classical” and “New Keynesian” research programs, asking why monetarism as a labeled school essentially disappeared even though De Long argues most of its substance did not. He distinguishes four successive subspecies. First Monetarism (Fisher’s own quantity-theoretic tradition) is judged to have failed chiefly because it lacked a sophisticated business-cycle theory, a gap that helped drive Keynes away from quantity theory altogether. Old Chicago Monetarism (the pre-war Viner-Simons-Knight “oral tradition”) stressed that velocity was unstable and that fractional-reserve banking made the money supply hard to control – though De Long treats the long-running dispute over whether this was ever a coherent “theory,” rather than retrospectively systematized policy views, as beside the point. Classic Monetarism – Friedman’s mature postwar synthesis – combined durable empirical and analytical contributions (stable money demand even under hyperinflation, the limits of stabilization policy given uncertain lags, the case for rule-based policy, the natural-rate-of-unemployment hypothesis, and the demonstrated potency of monetary policy) with an institutional-reform program (100 percent reserve banking plus constant money growth) that, De Long notes, never took hold as financial deregulation moved the other way. Political Monetarism, the simplified doctrine that briefly became official Federal Reserve and Bank of England policy in the late 1970s, went further than Classic Monetarism by treating velocity as simply stable and the money stock as a sufficient statistic for nominal demand – and it is this subspecies, De Long argues, that “crashed and burned” in the 1980s as Goodhart’s Law took hold and targeted aggregates lost their predictive power. De Long’s overall claim is that five analytical “planks” he associates with New Keynesian economics – nominal rigidities as the central business-cycle friction, the relative potency of monetary over fiscal policy, analyzing cycles around trend rather than below potential, evaluating policy through rules rather than case-by-case, and recognizing firm limits on what stabilization policy can achieve – all originate substantially in Friedman’s Classic Monetarism, so that the intellectual content of monetarism survives pervasively today even though the label itself, tainted by Political Monetarism’s empirical collapse, does not.

Vector Autoregressions

This 2001 Journal of Economic Perspectives paper by James Stock and Mark Watson reviews how vector autoregressions (VARs) have performed at the four core tasks of applied macroeconometrics — data description, forecasting, structural inference, and policy analysis — roughly twenty years after Christopher Sims’s original 1980 proposal, illustrated throughout with a simple three-variable system (inflation, unemployment, and the federal funds rate) estimated on quarterly U.S. data, 1960-2000. The authors find VARs perform strongly at data description (Granger-causality tests, impulse responses, and variance decompositions reveal, for example, that inflation and unemployment shocks jointly account for about 75% of the federal funds rate’s forecast-error variance at a three-year horizon) and provide a solid forecasting benchmark (a small VAR modestly outperforms both a univariate autoregression and a random walk at most horizons in a pseudo out-of-sample exercise), but they are considerably more skeptical about structural inference and policy analysis. Structural VAR identification is criticized on three grounds — omitted-variable bias (illustrated by the “price puzzle,” which arises when variables the Fed actually used to forecast inflation, like commodity prices, are left out of the model), parameter instability in monetary policy rules over long samples, and implausible zero-restriction timing conventions that are sometimes dressed up as “structural” theory without real economic content — and the paper shows that structural impulse responses can be “very sensitive” to seemingly minor changes in the assumed policy rule (switching from a backward-looking to a forward-looking Taylor rule roughly doubles the estimated inflation and unemployment responses to a funds-rate shock). The authors conclude that VARs’ “structural implications are only as sound as their identification schemes,” and that combining good economic theory and institutional detail with flexible statistical methods like VARs remains the central ongoing challenge for the field.