## Monetary Policy AnalysisBennett T. McCallum The past several years have seen very rapid development in the area of monetary
policy analysis.
Much of this recent work has used the following approach: the researcher specifies a quantitative macroeconomic model that is intended to be structural (invariant to policy changes) and consistent with both theory and evidence. Then, analytically or by stochastic simulations, he determines how crucial variables such as inflation and the output gap behave on average under various hypothesized policy rules. Normally, rational expectations is assumed throughout. Evaluation of the outcomes can be accomplished by reference to an explicit objective function or left to the judgement (that is, implicit objective function) of the policymaker. Optimal control techniques may or may not be involved. There is also considerable agreement about the general, broad structure of the
macroeconomic model to be used -- but much disagreement over details. For the
simplest closed-economy analysis a three-equation system is often used, involving just 1)
an optimizing "IS" type of intertemporal spending relation; a price adjustment relation;
and 2) an interest rate policy rule of the general Taylor type. The basic logic of the
analysis is not affected if (1) and (2) are sets of equations representing "sectors" of the
model, rather than single equations. A major development over the past 10-15 years is
the tendency of researchers to use versions of (1) and (2) that are based on optimizing
analysis of individual agents in a dynamic, stochastic setting. Often the price adjustment
relation is based on the work of Calvo and Rotemberg, although there continues to be
much dispute concerning the theoretical and empirical adequacy of this specification.
More generally, my recent work has conformed in large measure to the approach
just outlined. Papers with Nelson appear in both the Taylor volume and the
JME issue
mentioned earlier. A second way in which my work represents an extension of the basic model
concerns the role of capital. Much of the literature treats the stock of productive capital
as fixed or exogenous. One feature of the literature under discussion is that most models include no
money-demand function and no variable reflecting quantities of any monetary aggregate.
The usual optimizing analysis justifies this omission, however, only if the specification
of the function for transaction costs (which are reduced by holdings of real money
balances) is separable in money and the spending variable. Two recent papers of mine
argue that such separability is implausible; I conduct investigations of the magnitude of
the implied misspecification. There are a few ways in which my work differs from much of the current
research, though. One is its emphasis on the difficulty of measuring the "output gap"
variable that appears in price-adjustment and Taylor-rule equations, that is, the
percentage difference between current output and its "potential" or "natural-rate" value.
Papers written with Nelson and on my own argue that ignorance of the reference value is
not a matter of simple measurement error, but rather a conceptual uncertainty that is
likely to be long-lasting. A methodological paper argues strongly for the general approach to policy
analysis outlined at the start of this report.
A substantial portion of my recent work has been devoted to the contention that
one small but prominent strand of the recent literature is misguided. This strand features
rational expectations "indeterminacies" that occur under various conditions pertaining to
policy-rule design. In several papers, I have emphasized that the aberrations in question
reflect multiple (real) solutions of the "bubble" or "sunspot" type, not purely nominal
indeterminacies of the sort discussed in the classic monetary writings of Lange, Gurley
and Shaw, Johnson, and especially Patinkin. All of these warnings are, I suggest, spurious. My position on these indeterminacy issues is admittedly idiosyncratic, but could therefore be of greater value if correct.
1. McCallum is a Research Associate in the NBER's Program on Monetary Economics and the H. J. Heinz Professor of Economics at Carnegie Mellon University. 2.
For useful reviews, see R. Clarida, J. Gali, and M. Gertler, "The Science of Monetary Policy: A New
Keynesian Perspective," 3.
J.B. Taylor, ed., 4.
J.B. Taylor, "Discretion versus Policy Rules in Practice," 5.
This issue, and others involving model specification, is discussed briefly in B.T. McCallum, "Should
Monetary Policy Respond Strongly to Output Gaps?"
NBER Working Paper No. 8226,
April 2001, and 6.
Notable publications include M. Woodford, "Price Level Determinacy Without Control of a Monetary
Aggregate," 7.
B.T. McCallum and E. Nelson, "Performance of Operational Policy Rules in an Estimated Semi-Classical
Structural Model,"
NBER Working Paper No. 6599,
June 1998, and J.B. Taylor, ed., 8.
B.T. McCallum and E. Nelson, "Monetary Policy for an Open Economy: An Alternative Framework with
Optimizing Agents and Sticky Prices,"
NBER Working Paper No. 8175,
March 2001, and 9.
This practice is not universal, of course. Notable exceptions include R.G. King and A. Wolman,
"Inflation Targeting in a St. Louis Model of the 21st Century," Federal Reserve Bank of St. Louis Review
78 (May/June 1996), pp. 83-107; and T. Yun, "Nominal Price Rigidity, Money Supply Endogeneity, and
Business Cycles," 10. M. Casares and B.T. McCallum, "An Optimizing IS-LM Framework with Endogenous Investment," NBER Working Paper No. 7908, September 2000. 11.
B.T. McCallum, "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates,"
NBER Working Paper No. 7677,
April 2000, and 12. This finding is consistent with the econometric analysis of P.N. Ireland, "Money's Role in the Monetary Business Cycle," NBER Working Paper No. 8115, February 2001. 13. B.T. McCallum and E. Nelson, "Timeless Perspective vs. Discretionary Monetary Policy in Forward-Looking Models," NBER Working Paper No. 7915, September 2000; and B.T. McCallum, "Should Monetary Policy Respond Strongly to Output Gaps?" NBER Working Paper No. 8226, April 2001. Also relevant in this regard is A. Orphanides, "The Quest for Prosperity without Inflation," ECB Working Paper Series 2000-15, March 2000. 14.
B.T. McCallum, "Analysis of the Monetary Transmission Mechanism,"
NBER Working Paper No. 7395,
October 1999, and 15.
B.T. McCallum, "Issues in the Design of Monetary Policy Rules,"
NBER Working Paper No. 6016,
April 1997, and J.B. Taylor and M. Woodford, eds., 16.
Most notable of many publications is G.W. Evans and S. Honkapohja, 17.
B.T. McCallum, "Role of the Minimal State Variable Criterion in Rational Expectations Models,"
NBER Working Paper No. 7087,
April 1999, and 18.
First noted by M. Woodford, "Nonstandard Indicators for Monetary Policy: Can Their Usefulness Be
Judged from Forecasting Regressions?" in 19.
For example, J. Benhabib, S. Schmitt-Grohe, and M. Uribe, "The Perils of Taylor Rules," |

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