NBER Reporter: Summer 2001

Monetary Economics

The NBER's Program on Monetary Economics, directed by Ben S. Bernanke of Princeton University, met in Cambridge on April 27. The following papers were discussed:

George W. Evans, University of Oregon, and Seppo Honkapohja, University of Helsinki, "Expectations and the Stability Problem for Optimal Monetary Policies"

Discussant: Bennett McCallum, NBER and Carnegie-Mellon University

Eric T. Swanson, Federal Reserve Board, "Optimal Nonlinear Policy: Signal Extraction with a Non-Normal Prior"

Discussant: Noah Williams, University of Chicago

Susan Athey, NBER and MIT, Andrew Atkeson, NBER and University of California, Los Angeles, and Patrick J. Kehoe, NBER and University of Minnesota, "On the Optimality of Transparent Monetary Policy"

Discussant: Jon Faust, Federal Reserve Board

Robert J. Barro, NBER and Harvard University, and Sivana Tenreyro, Harvard University, "Closed and Open Economy Models of Business Cycles with Marked Up and Sticky Prices" (NBER Working Paper No. 8043)

Discussant: Mark Bils, NBER and University of Rochester

Christopher Otrok, University of Virginia, B. Ravikumar, Pennsylvania State University, and Charles H. Whiteman, University of Iowa, "Habit Formation: A Resolution of the Equity Premium Puzzle?"

Discussant: John C. Heaton, NBER and University of Chicago

Susanto Basu and Miles S. Kimball, NBER and University of Michigan, "Long-Run Labor Supply and the Elasticity of the Intertemporal Substitution for Consumption"

Discussant: Robert E. Hall, NBER and Stanford University

A fundamentals-based monetary policy rule, which would be optimal without commitment when private agents have perfectly rational expectations, is unstable if these agents in fact follow standard adaptive learning rules. This problem can be overcome if private expectations are observed and suitably incorporated into the policymaker's optimal rule. These strong results extend to the case in which there is simultaneous learning by the policymaker and the private agents. Evans and Honkapohja show the importance of conditioning policy appropriately, not just on fundamentals, but also directly on observed household and firm expectations.

Swanson offers a possible theoretical explanation for the Federal Reserve's relatively laissez-faire attitude toward historically low unemployment in the late 1990s. In models of optimal monetary policy under uncertainty, assumptions must be made about the structure of the economy and policymakers' beliefs about unobserved and uncertain variables, such as the natural rate of unemployment. Previous studies in the literature have made the simplifying assumption that these beliefs have a normal (Gaussian) distribution. Swanson relaxes this assumption to accommodate beliefs that are more diffuse (uncertain) in a region around the mean. He argues that this is a more plausible model given the possibility of structural change that many argued was occurring in the economy around that time. Swanson demonstrates that it becomes optimal for policymakers to be more open-minded and set interest rates more cautiously in response to observable indicators, such as unemployment, while at the same time becoming increasingly more aggressive at the margin. This model appears to match well statements by Federal Reserve officials, and the historical behavior of the Fed, in the late 1990s.

Athey, Atkeson, and Kehoe analyze the optimal design of monetary rules. They suppose that there is an agreed upon social welfare function which depends on the randomly fluctuating state of the economy and that the monetary authority has private information about that state. They further suppose that the government can constrain the policies of the monetary authority by legislating a rule. Surprisingly, the authors show that for a wide variety of circumstances the optimal rule gives the monetary authority no flexibility. This rule can be interpreted as a strict inflation targeting rule where the target is a prespecified function of publicly observed data. In this sense, optimal monetary policy is transparent.

Shifts in the extent of competition, which affect markup ratios, are possible sources of aggregate business fluctuations. Markups are countercyclical, and booms are times at which the economy operates more efficiently. Barro and Tenreyro begin with a real model in which markup ratios correspond to the prices of differentiated intermediate inputs relative to the price of undifferentiated final product. If the nominal prices of the differentiated goods are relatively sticky, then unexpected inflation reduces the relative price of intermediates and thereby mimics the output effects from an increase in competition. In an open economy, domestic output is stimulated by reductions in the relative price of foreign intermediates and, therefore, by unexpected inflation abroad. The various versions of the model imply that the relative prices of less competitive goods move countercyclically. The authors find support for this hypothesis from price data of four-digit manufacturing industries.

Otrok, Ravikumar, and Whiteman explore how the introduction of habit preferences into the simple intertemporal consumption-based capital asset pricing model "solves" the equity premium and risk-free rate puzzles. While agents with time-separable preferences care only about the overall volatility of consumption, the authors show that agents with habit preferences care not only about overall volatility, but also about the temporal distribution of that volatility. Specifically, habit agents are much more averse to high-frequency fluctuations than to low-frequency fluctuations. In fact, the size of the equity premium in the habit model is determined by a relatively insignificant amount of high-frequency volatility in the U.S. consumption. Further, the model's premium and returns are very sensitive to changes in characteristics of the stochastic process for consumption, changes that have been dramatic during the twentieth century. The model also carries counterfactual implications the equally dramatic changes in the equity premium and risk-free rate observed over the last hundred years.

According to Basu and Kimball, the fact that permanent increases in the real wage have very little effect on labor supply implies a parameter restriction in the consumption Euler equation augmented by predictable movements in the quantity of labor. This parameter restriction is confirmed with aggregate U.S. data. The implied estimate of the elasticity of intertemporal substitution is around .35, and is significantly different from zero. This estimate is robust to different instrument sets and normalizations. After accounting for the effects of predictable movements in the labor implied by the restriction, there is no remaining evidence in aggregate U.S. data of excess sensitivity of consumption to current income.

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