Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory*

Questions & answers

Q1. What exactly does the paper’s policy rule say, and why forward-looking rather than backward-looking?

The rule sets the Federal Funds rate target as a linear function of the gap between the central bank’s expectation of future inflation (over a horizon k) and its inflation target, plus the expected output gap over horizon q (Section II.A, p. 150-151, eq. 1). The authors adopt a forward-looking specification because it “allows the central bank to consider a broad array of information (beyond lagged inflation and output) to form beliefs about the future condition of the economy, a feature that we find highly realistic” (p. 151), and they show formally that their rule nests Taylor’s (1993) backward-looking rule as a special case when lagged variables happen to be sufficient statistics for forecasting future inflation.

Q2. How do the pre-Volcker and Volcker-Greenspan estimates of the inflation-response coefficient actually differ, and how robust is the difference?

The baseline GMM estimate of β, the coefficient on expected inflation, is 0.83 (s.e. 0.07) for 1960:1-1979:2 and 2.15 (s.e. 0.40) for 1979:3-1996:4 (Table II, p. 157) – “significantly below unity for the pre-Volcker period… and far greater than one for the Volcker-Greenspan period” (p. 157). The authors show this pattern survives switching to detrended output or the unemployment rate as the output-gap measure and CPI instead of the GDP deflator (Table III), extending the inflation/output horizons to one year (Table IV), splitting each era by individual Fed chairman – Martin, Burns-Miller, Volcker, Greenspan, and post-1982 alone (Table V) – and using a purely backward-looking Taylor-type specification instead (Table VI): “the key insights obtained in the baseline case are robust to allowing for structural changes across Chairmen. In particular, the striking difference in the reaction function across time is the rise in the slope coefficient on inflation from slightly less than unity pre-Volcker to around two in the Volcker-Greenspan era” (p. 165).

Q3. What does it mean, mechanically, that the Fed let real rates decline pre-Volcker?

Because the estimated inflation coefficient was below one, the Fed’s nominal-rate response to a rise in expected inflation was smaller than the rise in expected inflation itself, so the implied real-rate target actually fell (Section II.B, eq. 2, p. 152-153; Section III.C, p. 165). “During the pre-Volcker period, in response to forecastable inflationary pressures, the Federal Reserve tended to let real interest rates decline or, at best, did not try to raise them… This kind of response clearly does not stabilize inflation under any plausible view of the linkages between real rates, aggregate demand, output, and inflation” (p. 165). Under Volcker-Greenspan, by contrast, the Fed “substantially raised target real rates in the wake of an anticipated increase in inflation (on a two-for-one basis, according to a rough average of our point estimates)” (p. 165).

Q4. Why do the authors think oil shocks cannot be the whole story for the 1970s?

They argue the timing is wrong and that multivariate evidence assigns oil only a modest role: inflation began rising in the late 1960s, well before the 1974 oil shock, while the real oil price was actually declining over that build-up (Section III.D, p. 166-167, citing De Long 1997 and Figure III). “The initial build-up of inflation in the late 1960s and early 1970s occurs prior to the first oil shock… until the time of the first oil shock in 1974, the real oil price is steadily declining, while inflation is steadily rising” (p. 167). Citing Bernanke-Gertler-Watson and Barsky-Killian, they also report that in a multivariate system, an oil-shock measure “accounts for at best roughly 10 percent of the variation in the GDP deflator over the period 1960:1 to 1984:4” (p. 167-168, fn. 27), and conclude that even granting oil shocks a role in the recessions, generating persistent inflation from them “in the absence of an accommodating monetary policy” is implausible (p. 168).

Q5. What is the theoretical model used to interpret the estimated rules, and what are its key equations?

A standard New Keynesian sticky-price model in the tradition of King-Wolman, Woodford, and Yun, log-linearized around a zero-inflation steady state into a forward-looking Phillips curve, an IS-type Euler equation, and the estimated policy rule with partial adjustment (Section IV.A, eqs. 6-9, p. 169-171). The Phillips curve (eq. 6) “can be derived from the aggregation of optimal price-setting decisions by monopolistically competitive firms” under Calvo-style staggered pricing (p. 170), and the IS equation (eq. 7) “combines a standard Euler equation for consumption with a market clearing condition” (p. 170). The model is calibrated with a quarterly discount factor of 0.99, risk aversion of 1, and an output-elasticity-of-inflation parameter of 0.30 “consistent with the empirical findings in Roberts [1995]” (p. 171, fn. 32).

Q6. Under what condition does the model admit self-fulfilling inflation/output fluctuations, and what do these look like?

When the inflation-response coefficient β is below one (as estimated for the pre-Volcker rule), the equilibrium is indeterminate and the model admits sunspot-driven fluctuations with no fundamental shocks at all (Section IV.B, p. 171-174). “With β below unity, a rise in anticipated inflation leads to a decline in the real interest rate. The decline in the real rate then stimulates aggregate demand which, in turn, induces a rise in inflation. The initial rise in expected inflation thus becomes self-confirmed” (p. 171). Simulating the pre-Volcker rule with random “sunspot shocks” to expectations, the authors find “persistent fluctuations in output and inflation… despite the absence of any fundamental shocks” (p. 171-172), whereas “self-fulfilling fluctuations cannot arise under the estimated interest rate rule for the Volcker-Greenspan period” because β is well above one (p. 174).

Q7. Even where the estimate isn’t strictly below one, does the pre-Volcker-type rule still matter for stability?

Yes – the paper shows that near-unity values of β leave the economy far more exposed to ordinary supply and demand shocks, independent of strict indeterminacy (Section IV.C, Table VII, p. 175-176). Holding the other estimated parameters fixed at their pre-Volcker values and varying β alone, “as β rises from one to two, the volatility of both output and inflation declines by more than half. This occurs for both the supply shock and the demand shock” (p. 175). Simulating a negative supply shock across β values from 1.01 to 2.00, “the supply shock produces a persistent effect on inflation only for values of β near unity… The accommodating pre-Volcker policy, it appears, can account for a persistent response of inflation. The same does not appear to be true for the Volcker-Greenspan policy” (p. 176-177) – i.e., the pre-Volcker-type rule can turn a transitory oil shock into 1970s-style persistent stagflation, but the Volcker-Greenspan-type rule cannot.

Q8. What open question does the paper explicitly leave unresolved?

Why the Federal Reserve followed a demonstrably inferior rule for roughly fifteen years before Volcker (Section V, p. 178-179). The authors offer only tentative, non-exclusive speculations – that the Fed may have persistently overestimated potential output or the natural rate (citing De Long 1997 and Orphanides 1997 on real-time output-gap misperception), or that “neither the Fed nor the economics profession understood the dynamics of inflation very well” at the time, since “it was not until the mid-to-late 1970s that intermediate textbooks began emphasizing the absence of a long-run trade-off between inflation and output” (p. 178) – and explicitly flag this as an open question “our paper raises but does not answer” (p. 178) rather than a settled conclusion.