NBER Reporter: Summer 2002

Monetary Economics

    The NBER's Program on Monetary Economics, met in Cambridge on April 12. NBER Research Associates Martin Eichenbaum and Lawrence Christiano, both of Northwestern University, organized this program:

    Michael Woodford, NBER and Princeton University, "Imperfect Common Knowledge and the Effects of Monetary Policy" (NBER Working Paper No. 8673)

    Discussant: V. V. Chari, University of Minnesota

    Nobuhiro Kiyotaki, NBER and London School of Economics, and John Moore, MIT, "Liquidity, Business Cycles, and Monetary Policy"

    Discussant: Harold Cole, University of California, Los Angeles

    George W. Evans, University of Oregon, and Seppo Honkapohja, University of Helsinki, "Monetary Policy, Expectations, and Commitment"

    Discussant: Marco Bassetto, University of Minnesota

    Mark Bils, NBER and University of Rochester, and Yongsung Chang, University of Pennsylvania, "Welfare Costs of Sticky Wages When Effort Can Respond"

    Discussant: Miles S. Kimball, NBER and University of Michigan

    Fernando Alvarez, NBER and University of Chicago; Andrew Atkeson, NBER and University of California, Los Angeles; and Christian Edmond, University of California, Los Angeles, "Can a Baumol-Tobin Model Account for Short-Run Behavior of Velocity?"

    Discussant: Julio J. Rotemberg, NBER and Harvard University

    Harold Cole and Lee Ohanian, University of California, Los Angeles, and Ron Leung, University of Minnesota, "Deflation, Real Wages, and the International Great Depression: A Productivity Puzzle"

    Discussant: Ben S. Bernanke, NBER and Princeton University

    Woodford reconsiders the Phelps-Lucas hypothesis, according to which temporary real effects of purely nominal disturbances result from imperfect information. He departs from the assumptions of Lucas (1973) in two crucial respects, though. Because of monopolistically competitive pricing, higher-order expectations are crucial for aggregate inflation dynamics, as Phelps argued (1983). And, decisionmakers' subjective perceptions of current conditions are assumed to be of imperfect precision, because of finite information processing capacity, as Sims argued (2001). The model can explain highly persistent real effects of a monetary disturbance and a delayed effect on inflation.

    Kiyotaki and Moore provide a simple framework for modelling differences in liquidity across assets. Their goal is to understand the interaction between asset prices and aggregate economic activity, and to explain liquidity premiums. In so doing, they examine the role of government policy, through open market operations, in changing the mix of assets held by the private sector. They also show that certain anomalies of the real economy, such as low rates of return on liquid assets, volatility of asset prices, and limited participation in asset markets, in fact are normal features of an economy where money is essential for the smooth allocation of resources.

    In monetary policy, the equilibriums from full commitment are superior to those from optimal discretionary policies. A number of interest rate reaction functions and instrument rules thus have been proposed to implement or approximate full commitment policy. Evans and Honkapohja assess these optimal reaction functions and instrument rules in terms of whether they lead to an equilibrium that is both locally determinate and stable under adaptive learning by private agents. They find that a reaction function that appropriately depends explicitly on private expectations performs best on both counts.

    Bils and Chang examine the impact of wage stickiness when employment has an effort as well as an hours dimension. Despite wages being predetermined, the labor market clears through the effort margin. Consequently, welfare costs of wage stickiness are potentially much, much smaller.

    Alvarez, Atkeson, and Edmond describe the link between money, velocity, and prices in an inventory-theoretic model of the demand for money. They then explore the extent to which such a model can account for the short-run volatility of velocity, the negative correlation of velocity, the ratio of money to consumption, and the resulting "stickyness" of the aggregate price level as measured by the relative volatility of the ratio of money to consumption and the price level. They find that an inventory-theoretic model of the demand for money is a natural framework for understanding these aspects of the behavior of velocity in the short run.

    The high-real-wage story is one of the leading hypotheses for how deflation caused the international Great Depression. Theoretically, world-wide deflation combined with incomplete nominal wage adjustment raised real wages in a number of countries. These higher real wages reduced employment as firms moved up their labor demand curves. This implies a strong negative correlation between deviations in output and real wages, while the correlation in the data is positive. The positive correlation implies the need for another shock to act as a shifter of labor demand. Cole, Ohanian, and Leung assume that the other shock works through productivity. They evaluate the relative contributions of productivity shocks and money shocks (operating through high real wages) to output changes for 17 countries between 1930 and 1933. They estimate that about two-thirds of output changes in the international cross section are explained by a productivity or productivity-like shock which is orthogonal to deflation, and about one-third of output changes are explained by money shocks.

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