Title: Gnter W' Beck and Volker Wieland
1Central Bank Misperceptions and the Role of Money
in Interest Rate Rules
- Günter W. Beck and Volker Wieland
- University of Frankfurt and Center for Financial
Studies - Conference on John Taylors Contributions to
Monetary Theory and Policy - Dallas, October 12-13, 2007
2Cast in order of appearance in this paper
- Policy rules ( Taylors rule)
- Inflation and output volatilities under
uncertainty (Taylors curve) - Learning and policy design (Taylors dissertation)
3Monetary policy rules and money Taylor,
Friedman, Woodford, Lucas
- Taylors interest in developing effective rules
for government policy has been a driving force
for his research, cf.Taylor (2006) - Taylor (1979) showed that a fixed money growth
rule a Friedman rule - would have led to better
performance than actual policy in the post World
War II period ... (but) a money growth rule which
responded to economic developments could do even
better. - Since then I have found that policy rules in
terms of interest rates have worked better as
practical guidelines for central banks.
4Friedman (06) taking Taylors perspective with i
instead of m as instrument
- The Taylor rule is an attempt to specify the
federal funds rate that will come closest to
achieving the theoretically appropriate rate of
monetary growth to achieve a constant price level
or rate of inflation. - Suppose a Taylor rule that gives 100 percent
weight to inflation deviations. That may not be
the right rate..because other variables such as
output or monetary growth are not at their
equilibrium levels. - ..additional terms in the Taylor rule would
reflect variables relevant to choosing the right
target funds rate to achieve the desired
inflation target.
5So add money as a right-hand-side variable in a
Taylor-style rule?
- New-Keynesian models - No!
- Woodford (2006) writes
- Serious examination of the reasons given thus
far for assigning a prominent role to monetary
aggregates in (policy) deliberations provides
little support for a continued emphasis on those
aggregates. - Lucas (2007) expresses some concern regarding the
increasing reliance of central bank research on
New-Keynesian modeling.
6Money as a cross-check?
- Lucas (2007)
- Money supply measures play no role in the
estimation, testing or policy simulation of these
models formulated in terms of deviations from
trends that are determined off stage (they)
could be reformulated to give a unified account
of trends, including monetary aggregates, and
deviations ... - This remains an unresolved issue on the frontier
of macroeconomic theory. Until it is resolved,
monetary information should continue be used as a
kind of add-on or cross-check.
7Our objective
- Incorporate cross-checking with regard to
monetary trends in Taylor-style interest rate
rules, (Beck and Wieland, JEEA 2007). - Use historical output gap misperceptions to show
that central bank beliefs cause persistent policy
errors and drive money and inflation trends. - Show that monetary cross-checking improves
inflation control by correcting repeated policy
errors. - Show that monetary cross-checking even remains
effective in case of sustained velocity shifts,
if the central bank learns i.e. recursively
estimates money demand allowing for shifts.
81. Cross-checking
- Interest rate rule with 2 components
- (1)
- iT could by Taylor-style rule, or the
interest rate policy implied by loss function
minimization in a given model. - iM refers to the interest-rate adjustment due
to cross-checking. Systematic, but infrequent,
triggered by a statistical test of a key
relationship!
9Monetary cross-checking
- Step 1 Cross-checking trend in adjusted money
growth against the inflation target and testing
for a mean shift - (2)
- i.e. check if ?gt?crit or ?lt -? crit for N
periods.
10Monetary cross-checking
- Step 2 If there is evidence for a shift then
change interest rate levels appropriately. - (3)
- ... change if ?gt?crit or ?lt -? crit for N
periods.
11Why cross-check with a monetary (trend) measure?
- Why Lucas talks about trends
- (Benati 2005)
12Deriving the monetary (trend) measure for
cross-checking
- (4) Money demand
- (5) Money growth and inflation in the short-run
- (6) Money growth and inflation in the long-run
13The monetary (trend) measure for cross-checking
- (7) Long-run empirics filtered adjusted money
growth moves with filtered inflation. - (8) Definiton of filter as in Gerlach (2004).
14Strategy for evaluating role of money
- Consider 2 models (eqns in Table 1, page 11)
- Keynesian-style model (K-model) as in Svensson
(1997), OrphanidesWieland (2000). - New-Keynesian model (NK-Model) as in Clarida,
Gali and Gertler (1999). - Optimal policy expressed as Taylor-style rule
- K-Model Taylor rule with lagged inflation and
output gap, but coefficients greater than 0.5. - NK Model Optimal policy under discretion
corresponds to Taylor-style rule with inflation
forecast and perceived demand shock.
15Strategy continued
- Show that in both models optimal interest rate
policy with historical output gap misperceptions,
leads to sustained money and inflation trends. - Misperception perceived potential differs from
true value.
16Strategy continued
- Note, to sharpen the focus we consider a central
bank that cares only about inflation deviations
from a zero target. Thus, the f.o.c.is - Then, we apply the same policy rules in
conjunction with monetary cross-checking.
17Policy objective and optimal interest rate
policies
- Policy objective
- K-Model optimal policy under uncertainty
18Policy objective and optimal interest rate
policies
- NK-Model Interest rate setting implied by
optimal policy under discretion -
- In both cases money does not matter, but
inflation forecast depends on output gap and
policy.
19The Models
20The Parameters
21A Simple New-Keynesian Model
- Following Clarida, Gali, Gertler (1999)
- (1) Output gap
- (2) Phillips
- (3) IS
- Note superscript e Et
22NK Model Includes Persistent Shocks
23Noise and Misperceptions in NK Model
- (9) Noise Actual shocks differ from perception
24U.S. output gap misperceptions
Orphanides, The quest for prosperity without
inflation, Journal of Monetary Economics, 2003.
25The Bundesbanks output gap misperceptions
Gerberding, Seitz, Worms, How the Bundesbank
really conducted policy, North American Journal
of Economics and Finance, 2005.
262. Money and inflation trends due to historical
misperceptions
US Orphanides, The quest for prosperity without
inflation, J.Monetary Economics, 2003. Germany
Gerberding, Seitz, Worms, How the Bundesbank
really conducted policy, North American Journal
of Economics and Finance, 2005.
27Money and inflation trends due to historical
misperceptions
- Central bank persistently overestimates potential
and misperceives the output gap. - As a result, interest rates are set too low for a
sustained period of time. - Output ends up higher than required to maintain
price stability. - Money growth and inflation rise for a sustained
period of time.
28NK optimal interest rate with misperception
- Persistent misperception implies that interest
rates are set too low or too high for a sustained
period of time.
29K-Model US-misperceptions
30K-Model US misperceptions Actual and perceived
output gap
31NK-Model Bundesbank misperceptions
32Trend measures K/NK-US/DE 1000 draws
333. Misperceptions and cross-checking
- K-Model US misperception with cross-checking
34NK model Bundesbank misperceptions with
cross-checking
351000 draws K/NK-US/DE with cross-checking
364. Cross-checking and velocity shifts
- Monetary cross-checking deals well with velocity
fluctuations due to ?y?y , ?i?i or ?e. - But what about sustained trends in velocity as
identified by Reynard (2004) or Orphanides and
Porter (2000, 2001).
37Sustained velocity shift of 2 when the central
bank never revises estimates
38Sustained velocity shift and cross-checking when
central bank learns
39Conclusions
- We have shown that historical central bank
misperceptions cause money and inflation trends
of similar extend and direction. - We have shown that combining the Taylor-style
rules or model-based optimal interest rate policy
with monetary cross-checking improves inflation
control. - We have shown that monetary cross-checking
remains effective in the presence of sustained
velocity shifts when the central bank updates its
money demand estimates and learns.