This paper reviews the recent literature on monetary policy rules. To organize the discussion, we exposit the monetary policy design problem within a simple baseline theoretical framework. We then consider the implications of adding various real word complications. We concentrate on developing results that are robust across a reasonable variety of competing macroeconomic frameworks. Among other things, we show that the optimal policy implicitly incorporates inflation targeting. We also characterize the gains from making credible commitments to fight inflation and consider the implications of frictions such as imperfect information and model uncertainty. Finally, we assess how proposed simple rules, such as the Taylor rule, square with the principles for optimal policy that we describe. We use this same metric to evaluate the recent course of U.S. monetary policy.

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The Science of Monetary Policy: A New Keynesian Perspective

We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker’s appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected ineation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of ineation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing.

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Monetary policy rules and macroeconomic stability: Evidence and some theory

Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

Monetary Theory and Policy

Since the seminal work of Krugman (1979), product variety has played a central role in models of trade and growth. In spite of the general use of love-of-variety models, there has been no systematic study of how the import of new varieties has contributed to national welfare gains in the United States. In this paper we show that the unmeasured growth in product variety from US imports has been an important source of gains from trade over the last three decades (1972-2001). Using extremely disaggregated data, we show that the number of imported product varieties has increased by a factor of four. We also estimate the elasticities of substitution for each available category at the same level of aggregation, and describe their behavior across time and SITC-5 industries. Using these estimates we develop an exact price index and find that the upward bias in the conventional import price index is approximately 1.2 percent per year – double the estimated impact due to hedonic adjustments on the CPI. The magnitude of this bias suggests that the welfare gains from variety growth in imports alone are 2.8 percent of GDP per year.

/pdf/globalization-and-the-gains-from-variety-3t7kyqz9ei.pdf

Globalization and the gains from variety

Since the seminal work of Krugman (1979), product variety has played a central role in models of trade and growth. In spite of the general use of love-of-variety models, there has been no systematic study of how the import of new varieties has contributed to national welfare gains in the United States. In this paper we show that the unmeasured growth in product variety from US imports has been an important source of gains from trade over the last three decades (1972-2001). Using extremely disaggregated data, we show that the number of imported product varieties has increased by a factor of four. We also estimate the elasticities of substitution for each available category at the same level of aggregation, and describe their behavior across time and SITC-5 industries. Using these estimates we develop an exact price index and find that the upward bias in the conventional import price index is approximately 1.2 percent per year. The magnitude of this bias suggests that the welfare gains from variety growth in imports alone are 2.8 percent of GDP.

/pdf/globalization-and-the-gains-from-variety-1xq8uo2x2z.pdf

Globalization and the Gains from Variety

We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor-changes in the federal funds rate target - and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a "current federal funds rate target" factor and a "future path of policy" factor, with the latter closely associated with Federal Open Market Committee statements.We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

/pdf/do-actions-speak-louder-than-words-the-response-of-asset-i1iax6rdao.pdf

Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements

Current macroeconomic models provide appealing, succinct descriptions of business cycle dynamics in the United States and other countries, but less is known about the extent to which these models accurately replicate the economy’s long-run characteristics. In part, this reflects that economists have far fewer observations about long-run behavior, given the limited sample sizes available. But while less is known about the long-run characteristics of the economy, many macroeconomic models impose very strong assumptions about this behavior— that the long-run levels of inflation and the real interest rate are constant over time and perfectly known by all economic agents. This paper empirically tests those assumptions and proposes alternative ones. Specifically, we focus on the effects of macroeconomic and monetary policy surprises on the term structure of interest rates. In many standard macroeconomic models, short-term interest rates tend to return relatively quickly to a deterministic steady state after a macroeconomic or monetary policy shock, so that these shocks have only transitory effects on the future path of interest rates. As a result, one would expect only a limited response of long-term interest rates to these disturbances. Putting this prediction in terms of forward rates, one would expect virtually no reaction of far-ahead forward rates to such shocks. The behavior of the U.S. yield curve appears, however, to contrast sharply with these predictions. In particular, we demonstrate that longterm forward rates move significantly in response to the unexpected components of many macroeconomic data releases and monetary policy announcements. We interpret these findings as indicating that an assumption made in these models—that the long-run expectations of economic agents are precise and time-invariant—is violated. In particular, our empirical results are all consistent with a model that we present in which private agents’ views of long-run inflation are not strongly anchored.

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The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models

Since December 2008, the Federal Reserve’s traditio nal policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as th e economic outlook deteriorated, the Federal Reserve purchased substan tial quantities of assets with medium and long maturities. In this paper, we expl ain how these purchases were implemented and discuss the mechanisms through which they can affect the economy. We present evidence that the purchases le d to economically meaningful and long-lasting reductions in longer-te rm interest rates on a range of securities, including securities that were not incl uded in the purchase programs. These reductions in interest rates primarily reflec t lower risk premiums, including term premiums, rather than lower expectations of fu ture short-term interest rates.

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The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases

The discount function, which determines the value of all future nominal payments, is the most basic building block of finance and is usually inferred from the Treasury yield curve. It is therefore surprising that researchers and practitioners do not have available to them a long history of high-frequency yield curve estimates. This paper fills that void by making public the Treasury yield curve estimates of the Federal Reserve Board at a daily frequency from 1961 to the present. We use a well-known and simple smoothing method that is shown to fit the data very well. The resulting estimates can be used to compute yields or forward rates for any horizon. We hope that the data, which are posted on the website, and which will be updated periodically, will provide a benchmark yield curve that will be useful to applied economists.

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Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. The U.S. Treasury Yield Curve: 1961 to the Present

Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy.

/pdf/measuring-the-reaction-of-monetary-policy-to-the-stock-hy1vsg974f.pdf

Brian P. Sack

Papers

Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements

The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models

The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. The U.S. Treasury Yield Curve: 1961 to the Present

Measuring The Reaction of Monetary Policy to the Stock Market