Macroeconomic Models and Monetary Policy

Paul De Grauwe is critical of the macroeconomic models used by central banks:

Cherished myths fall victim to economic reality, by Paul De Grauwe, Commentary, Financial Times: ...But that is not the world of the macro­­economic models that are now in use in central banks. The world of these models is one of supernatural and God-like creatures for which the world has few secrets. These creatures can perfectly compute the risks they take and estimate with great precision how an oil price shock will affect their present and future production and consumption plans. They may not be able to predict each shock, but they know the probability distribution of these shocks. Thus the risk involved in financial instruments is correctly evaluated by individuals populating these models.

These superbly informed individuals want the central bank to keep prices stable so that as consumers they can optimally set their consumption plans with minimal uncertainty, and as producers they can set prices equal to marginal costs (plus a mark-up). If the central banks keep prices stable, these individuals, helped by well-functioning markets, will take care of all the rest and ensure that the outcome is the best possible one. This is a world in which free and unfettered markets are always efficient.

This is also a world where individual agents cannot make systematic mistakes. Their consumption and production plans are optimal. They will never build up unsustainable debts. In the world of these macroeconomic models financial crises should not occur. And if they do, it cannot be because of malfunctioning markets. Governments that impose silly constraints on rational individuals are messing things up, and central banks that do not keep their promises to maintain price stability are the source of macroeconomic instability. ...

There is a danger that the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.

There is quite a bit of research on monetary policy that is devoted to the issues he is worried about, particularly the literature on adaptive learning. See here, and some of his publications here for and example from a European central bank. These ideas are also well-known and of considerable interest to the US Fed, e.g. one example is here, but there are many more. Some of the recent work of Chris Sims is also of interest in this regard:

...Most recently, theories that postulate deviations from the assumption of rational, computationally unconstrained agents have drawn attention. One branch of such thinking is in the behavioral economics literature (Laibson, 1997; Benabou and Tirole, 2001; Gul and Pesendorfer, 2001, e.g.), another in the learning literature (Sargent, 1993; Evans and Honkapohja, 2001, e.g.), another in the robust control literature (Giannoni, 1999; Hansen and Sargent, 2001; Onatski and Stock, 1999, e.g.).

This paper suggests yet another direction for deviation from the seamless model, based on the idea that individual people have limited capacity for processing information. That people have limited information-processing capacity should not be controversial. It accords with ordinary experience, as do the basic ideas of the behavioral, learning, and robust control literatures. The limited information-processing capacity idea is particularly appealing, though, for two reasons. It accounts for a wide range of observations with a relatively simple single mechanism. And, by exploiting ideas from the engineering theory of coding, it arrives at predictions that do not depend on the details of how information is processed.

Returning to the article above criticizing macroeconomic models, the author goes on to explain why he thinks the reliance of central banks on macroeconomic models is a problem:

This intellectual framework helps to explain the single-minded focus of many central bankers on inflation. Clearly, inflation is important and maintaining price stability is an important task of the central bank. It is not the only task, though. Financial stability is equally important. But this dimension is completely absent from the macroeconomic models now in use.

Perhaps more attention to financial market instability is warranted, there's a lot of work on that currently underway, but as this overview of the learning literature makes clear, if you drop the rational expectations assumption and assume agents must learn about their economic environment (one means of generating financial market instability), it may still be that the an aggressive response to inflation is optimal:

Expectations, Learning and Monetary Policy: An Overview of Recent Research, by George W. Evans and Seppo Honkapohja, July 16, 2008: ...contemporaneous Taylor-type interest-rate rules should respond to the inflation rate more than one for one in order to ensure determinacy and stability under learning...

So central banks' focus on inflation comes solely from examination of standard macroeconomic models.

The point is that, unlike the implication in the article, central banks are quite anxious to explore the implications of agents that are less than fully informed or fully rational, how that impacts behaviors such as risk assessment, and to examine the implications of financial market instability. They are particularly interested in how these factors impact the conduct of stabilization policy. The models aren't perfect, and standard models do miss a lot of these elements, but standard models are not all we have and central bankers are quite aware of, and actively engaged in exploring the policy implications of alternative theoretical structures that can tell us more about these issues.

Comments

[hari]

From a purely political economy perspective, the concept of above macroeconomic monetary model is bunk principally because of the implied assumption of perfect equilibrium. In other words, the beginning of the truth is that there is no so-called perfect financial market system under which the standard model can be replicated.

Recent economic history tells us, in fact, the model is nothing more than a tool in framing the policy guidelines without an irrevocable ability to control its (im)perfect implementation.

Otherwise how does one explain the egregious breakdown of the macroeconomic monetary model - from one business cycle to another.

Me, I suspect even behavioural science will not be able to find an easy answer to the fallacy of the macroeconomic monetary model and raison detre of its financial policy imperative. Or, is it possible the financial system itself is intellectually (structurally) fraudulent?

[hari]

From a purely political economy perspective, the concept of above macroeconomic monetary model is bunk principally because of the implied assumption of perfect equilibrium. In other words, the beginning of the truth is that there is no so-called perfect financial market system under which the standard model can be replicated.

Recent economic history tells us, in fact, the model is nothing more than a tool in framing the policy guidelines without an irrevocable ability to control its (im)perfect implementation.

Otherwise how does one explain the egregious breakdown of the macroeconomic monetary model - from one cycle to another.

Me, I suspect even behavioural (economic) science will not be able to find an easy answer to the fallacy of the macroeconomic monetary model and *raison detre* of its
policy imperative.

Or, is it possible, the system itself is intellectually ie. structurally fraudulent?

[hari]

From a purely political economy perspective, the concept of above macroeconomic monetary model is bunk principally because of the implied assumption of perfect equilibrium. In other words, the beginning of the truth is that there is no so-called perfect financial market system under which the standard model can be replicated.

Recent economic history tells us, in fact, the model is nothing more than a tool in framing the policy guidelines without an irrevocable ability to control its (im)perfect implementation.

Otherwise how does one explain the egregious breakdown of the macroeconomic monetary model - from one cycle to another.

Me, I suspect even behavioural (economic) science will not be able to find an easy answer to the fallacy of the macroeconomic monetary model and *raison detre* of its
policy imperative.

Or, is it possible, the system itself is intellectually ie. structurally fraudulent?

[hari]

Sorry! Problems again with typepad - posting.

[2slugbaits]

I don't know where the author got the idea that central banks in general (and presumably he is criticizing the Fed in particular) aren't interested in expanding their models. Afterall, each quarter most of the Fed banks publish plenty of papers that are accessible to an informed public (i.e., not overly wonkish) and more than a few of these papers explore peoples' responses to inflation expectations, effect of windfalls on consumption, welfare effects of inflation, etc. Maybe I'm wrong, but I've never gotten the sense that the Fed prays to one standard model and no other gods shall come before it. That's especially hard to believe given Bernanke's temperment and intellectual association with Chris Sims.

I find myself getting increasingly annoyed with pundits who criticize the Fed for primarily focusing on inflation. Well, containing inflation is the Fed's primary directive (Humphrey-Hawkins rhetoric notwithstanding); but more to the point, most of the tools available to the Fed involve controling one variable, market liquidity. Being able to control one variable means that normally you can only attend to one problem at a time, not five problems. This Paul De Grauwe guy blames the Fed for having a monolithic macro model (call it the 3M's), but I think he's at least as guilty of assuming all of the country's economic problems must be solved by one and only one (monolithic?) government agency called the central bank. Last time I checked we still had a President and (somewhat castrated) Congress with shared responsibility for fiscal policy. I believe we still have an SEC. The Treasury hires an awful lot of economists, so I'm guessing that they also research various macro models.

[MattY]

If you model the economic agent as something that operates with good efficiency when the SNR of his estimation is around 10, you will do fairly good, except for the one thing being collective restructuring problem. Economic agents may operate their Kalman filters around 10 SNR, but they will also operate off nominal for medium short periods in order to await the volatility they need for restructuring.

It is this later effect that makes the Kalman filters we use to be unstable, the underlying model we use gets restructered during recession, we change models and restart the Kalman updates.

It is something about mammalian groups that we get economies of scale when the herd reverts to the flocking phenomena. In the case of humans, a recession becomes a giant labor auction and restructuring costs go down as a result. We get an economic gain from doing thing non-linear during periods of turbulence.

So the cycle the bank needs to worry about, then, is simple. Run the Kalman filter estimates of the macro economy. Watch the variance of the economic state over time. As the variance drops toward 10, and continues to drop beyond that, then we would expect the agents to be awaiting a volatility. The volatility they need to restructure can be measured as a Jensen Energy bond.

[Real Person from the Real World]

Models are tools. They should be tools for understanding the truth. Unfortunately bias in creating the model, bias in choosing inputs to the model, and bias in interpreting the results often comes into play. Systems are ultimately so complex, I don't think we have the true capabilities for creating really accurate models of many things, yet, if ever. Scientists keep saying they will unlock the brain and behavior, but every time, despite increasing understanding, they still fail. Actually, that is kind of heartening. I am tired of the rabid Darwinians trying to kill off God.

[john v]

models or no models, I find De Grauwe's argument a bit bizarre. From how I understand how complex and impersonal market info and signals are, all his criticisms
apply directly to the Fed itself. All this snark about the unrealistic assumptions of superbly informed individuals is precisely why so many free market thinkers are generally anti-Fed. Rothbardians are totally against it to the point of being gold bugs. Others are a bit less zealous and some limited role in money supply to deal with inflation but both types are definitely hostile to the impossible multi-mandate role of the Fed.

To me, the logic of the socialist calculation debate which totally undermines top-down economic control of prices also applies here. This is generally why Misesean types are so fixated on the Fed as the root of all these problems being discussed in terms of bubbles and mortgage crises.

So while many like De Grauwe note the imperfections, they seem to dance the real problem...namely that Fed is incapable of properly doing what it does...not because of models but because it is human.

Dr. Thoma,

Is this anti-fed stance, while accurate, simply unsatisfyingly basic and prohibitive? Is that why modern monetary policy refuses to be bound by it? Because it seems to me that no amount of knowledge or tricked has been able to really overcome the limitations and falibility of human hubris.

[odograph]

I hate to be a cynic, but are the models with highest prominence there because they are tools to understanding, or tools to sell policy?

I mean, yes Mark the answer that papers and alternate models exist is good as far as it goes ... but how many papers and models were used to shape the the Greenspan era?

(I think we had a sea change in the amounts of global investment capital looking for a home, and national policies that didn't adjust to that quite soon enough.)

[James Kroeger]

I find myself getting increasingly annoyed with pundits who criticize the Fed for primarily focusing on inflation. Well, containing inflation is the Fed's primary directive (Humphrey-Hawkins rhetoric notwithstanding.)The problem with the Fed's 'mission' is that it has conveniently sought to (1) optimize employment/growth, but (2) only up to the point when it begins to threaten price stability.

What we actually need is a central bank that will seek to (1) minimize inflation, but (2) only up to the point when it begins to threaten optimized output.

The Fed's current raison d'etre serves only the perceived interests of our society's 'Investment Class.'

They believe that rich people like them will be able to optimize their wealth if inflation is at a minimum.

If they had a clear understanding of their situation at the top of the economic ladder, they would realize that they can optimize their consumption of REAL WEALTH only if/when they are able to get every able-bodied and able-minded person in society producing something of value.

That only happens when their is a labor shortage is created and maintained by Congress through its power to spend.

If our Central Bank accepted this as its mission, it would actually be able to optimize our economic output while minimizing crime, human suffering, etc.

But why would it want to do anything like that?

Perhaps the best way is to get rid of the Federal Reserve system and put the Treasury Department in charge of the nation's money supply.

[robertdfeinman]

I'd like two make to psychological points.

First, about "adaptive learning". This implies that either a) individuals learn from experience or b) institutions do. Let's assume people learn from their experience (although there is plenty of evidence to the contrary such as leaning on "faith" or ideology of various kinds, or repeating destructive behavior). Well the "people" who learned are not necessarily the same people who will be confronted by the issue in the future. In fact that is one of the major complaints about things like bubbles or starting wars - the current actors weren't around last time.

As for institutions learning, this also depends upon have continuity of staff and of putting in place policies which reflect experience. However, as recent events have shown, there is little to prevent these institutions from abandoning this learning when a new generation comes along. Is the recent over expansion of financial institutions really any different from the follies of the conglomerates of 30 years ago? Do we need to see tainted meat in circulation again to learn why we have an FDA and agricultural department? The lessons were embedded in legislation which has been either trashed or ignored.

So, I'm doubtful about "adaptive learning" over more than a short period of time.

Point two has to do with motives. We know what the stated mandates of various central banks are, they are in their charters or enabling legislation. What we don't know is the motives of those put in charge of running these institutions. Obviously there is a question here, or the attitudes of those who get the jobs wouldn't be such a highly contested issue. Obviously Bernanke has a different approach to things than Greenspan, but should this be true if they are just functionaries without their own motives?

So, at any moment in time, we may have institutions which are pursuing various courses of action which are determined by the motives of their officials, even if they are broadly within the mandate of the institution. This ignores the fact that some of these officials may not be neutral actors, but really have the own personal agendas, whether political or self-serving. Corruption and revolving door employment is a serious problem in much of the world.

I have no idea what to do about the effect of human foibles on the running of institutions, but ignoring it won't make the issue go away. Technicians who focus on the mechanics of implementation may be restricting their work to their areas of expertise, but someone needs to look at the social aspects if it's not all to come to naught.

[Bruce Wilder]

In the late 1960's and early 1970's, there was a huge wave of enthusiasm for computer-calculated macroeconomic models. A large number of young academics started their careers at that time, buoyed by that enthuasiasm. Otto Eckstein made a forture with Data Resources (which continues as Global Insight, Inc.) As a gov't bureaucrat in the 1970's, I (tried to) use the Data Resources product in scenario planning and analysis.

These models did not work at all well then. It wasn't that they did not predict accurately; they could not even project plausibly -- variables did not keep plausible relations to one another. Insights as to why seemed sometimes to glimmer just beyond my comprehension. I did learn some interesting things about automobile demand from the inability of DR, Inc. to either predict it, or even to model it realistically in projections. By the late 1970's, even the DR principals themselves were clearly aware of the implausibility of their projections, and the company's practice shifted dramatically away from computer calculation toward having a small steering group of business economists tweak their forecasts manually. I remember going to a big show at the Pierre Hotel in NYC, where their star economist explained their intuitive reasoning. The computer and the model were nothing more than stage props, by that point. Sales tools, as it were.

But, how sad that more people did not focus on learning more about the economy worked from the failure of the models. The models, obviously, embodied a lot of false ideas about how the economy functioned. If economists could only be braver about having their theoretical prejudices ground fine by facts.

The economy is, itself, a giant engine of calcuation, which any individual computer is going to be seriously challenged to match. And, the Fed, itself, is too often the corrupted tool of the plutocracy, with a big stake in not acknowledging economic reality (say, choosing an example at random, not noticing or taking action regarding the biggest housing bubble of all time, driven by an orgy of fraudulent and predatory lending for which the Fed had regulatory responsibility).

[2slugbaits]

But, how sad that more people did not focus on learning more about the economy worked from the failure of the models. The models, obviously, embodied a lot of false ideas about how the economy functioned. If economists could only be braver about having their theoretical prejudices ground fine by facts.

But didn't they learn from those failures? The arguments against the Fed keep bouncing back and forth between blaming the Fed for too much hubris about its models, and then blaming the Fed for being too humble in seeing its mission too narrowly in terms of only controllig inflation and not trying to conquer unemployment, not poking speculative bubbles, unfavorable exchange rates, not mention failing to cure cancer and not washing my car.

The two lessons from the failures of the big models of the 60s and 70s seem to be that (1) inflation is not welfare enhancing; and (2) there are always more policy problems haunting us than there are policy tools available, so you focus on those problems that are most responsive to the tools that are available. In the case of the Fed that means trying to anticipate how changes in liquidity will affect inflation 12 months from now.

[flow5]

“Policy rules” are ex-post, (e.g, Taylor Rule). As applied, ‘true ups”, are necessarily lagging and staggered. In contrast, monetary flows (MVt), as defined, are ex-ante. With minor exceptions, forecasts are infallible. If you use the wrong criteria, you get the wrong result.

From 1996 until 2006, the “expansion coefficient” (money multiplier) rose at the fastest pace in the Fed’s history - +100% increase in 10 years (the period corresponding to Greenspan’s conundrum). During roughly this same time frame, housing prices climbed 83% in 5 years (Case-Schiller).

Before the latest breakdown, it took 35 years for the “MM” to double (1977-2005), the same rate as in the previous 30 years (1947-1977), - a predictable path. Consequently, “MM” (an important measuring instrument), has been undermined.

This in and of itself, is prima facie evidence that the Fed has lost any current way of monitoring, or controlling, the legal reserves, and therefore the stock of money, of any of our money creating, or potentially money creating, depository institutions.

[flow5]

Barring direct authoritarian controls, the only method by which the volume of the money stock can be properly regulated is through central bank control of commercial bank free-gratis legal reserves and reserve ratios (the minimal ratios of legal reserve assets held by the commercial banks to their deposit liabilities)

To be effective, the free-gratis legal reserves of member commercial banks must be confined to a bank asset that can be constantly monitored and controlled by the monetary authorities. Only Federal Reserve Bank inter-bank demand deposits (FRBIBDD) meet this condition. The volume of FRBIBDDs is almost exclusively related to the volume of Reserve Bank credit. That is Reserve Banks acquire Treasury Bills, etc., by creating IBDDs – the free legal reserves of money creating institutions.

[2slugbaits]

Flow5,

From 1996 until 2006, the “expansion coefficient” (money multiplier) rose at the fastest pace in the Fed’s history - +100% increase in 10 years

Could you explain what you mean here? I'm not following. A quick check over at FRED shows that MM has been steadily falling for a long time. Now if your argument is that due to globalization and the proliferation of all kinds of new financial instruments the long run tendency has been to undermine the Fed's ability to control key variables, then that's fine. In fact, I'm inclined to agree with it. But if you make that argument then it really seems bizarre to increase blame as the Fed's ability to control things diminishes.

[Barkley Rosser]

It is my understanding that there has recently been an increasing number of papers by people in both the Fed system and the ECB using heterogeneous agent-based modeling with learning and so on. De Grauwe, who used to build models of chaotic dynamics in foreign exchange rates, is certainly a supporter of this. I would note that in the Fed system some of the advocates of this approach are actually beginning to get into prominent positions of power, with the appointment of James Bullard to be president of the St. Louis Fed an example.

[Michael McKinlay]

The entire fractional reserve banking system is based upon the premise that there are infinite resources to supply the economy. It is becoming readily apparent that the world is indeed finite and that the geometric debt creation model of leveraged debt based fractional banking cannot function and will implode in an environment of diminishing resources and increased risk.

Trying to manipulate fractional reserve banking to the new paradigm of finite resources therefore finite debt and finite money is like fitting the square peg into the round hole. We need a public central bank that creates money without debt and an interest rate that is not manipulated but floats. Only when savings are equal to borrowings will there be stability in the money supply and the economy.

[don]

BB frightened me the other day when he cited the study by Hufbauer et al. He surely has qualified international economists at the Fed who know better. So much for my opinion of BB's integrity. I don't agree that it's OK to lie in a good cause (free trade). Dani R's analyis is clearly much closer to the truth. If the rest of the Fed's modeling is as bad, we may be in very serious trouble. Recall also their forecast of $70 a barrel for oil?

[One Salient Oversight]

The problem with central banks these days is that their inflation targets are too loose.

Think - what would have happened if the Fed had kept interest rates higher and inflation lower after the 2001 recession? Two things:

1) Slower economic growth.
2) No housing bubble.

Perhaps central banks need to revise their inflation fighting goals and aim at having even tighter monetary policy. Perhaps we need to aim for absolute price stability and ensure that the CPI is neither positive nor negative over the course of the business cycle.

It would certainly slow growth down, but it would also be enough to prevent asset price bubbles and possibly even cyclical recessions.

After all, if interest rates were higher, and inflation lower, post 2001, people would be throwing money into bank deposits rather than McMansions. With real interest rates reasonably high, people would not have lost their hard earned money... and the housing market would have functioned more efficiently methinks.

[hari]

With emergence of SWFs and other leveraged derivatives - the global monetary policy complex is getting more (not less) complicated for a so-called *standard model*.

Fed cannot continue to operate as a monolitihic financial regulator while most of its credit facility is rented out to emerging markets. Why would Paulson push (inspite of Bush) to bailout Fannie & Freddie? Simply because FF mortgage derivative instruments are now (almost all) held by Japan and China with GCC included exceeding more than trillion dollars.

Thereefore, I'd suggest, going forward will demand/require even more careful recognition of *other* actors on the global monetary field -> resulting invariably in affecting long term credibility of the standard monetary tools of regulatory controls.

[Eric Dewey]

This is an all-star lineup of economic commentators; it's impressive to read these thoughts.

I have no economic expertise, but the discussions of the political and human elements of the issue seem to indicate that there's a limit to what economics can offer, and that it might also be productive to explore other disciplines.

Two point leap out to me - first, that this is a question of balance: economic models are built to guide decisionmakers on the question of balancing competing interests (allocation of scarce resources).

Second, and perhaps more importantly from a political perspective, is that the time element seems to be insufficiently addressed - in the sense that, while in a negative economic crisis mode there is a strong practical desire among those who pay economists for their thoughts to understand how long any actual or projected imbalances will continue, the same employers rarely give much real attention to the reverse of the question during a strongly positive economic mode.

In other words, when things are going well for the dominant elites who pay the salaries of most economists, they're less willing to pay for an understanding of when things may turn sour, but when things are going poorly, they'll pay anything to know when things will get better.

This seems trivial - but is it really?

Is it possible that the assumption that actors behave in their own economic self-interest, upon which all economic models are currently based, fails simply because history demonstrates how rarely those with the greatest economic power are able to make decisions based on long-term considerations of sustainability?

Or is it possible to develop a model that assumes that economic elites act primarily in their own short-term self-interest but provides medium-to-long-term solutions for coping with the short-term failures of political and economic leadership?

(Please note that, since it is doubtful that the successful modeler will be paid directly for their efforts, and even more unlikely that anyone in power would actually implement the recommendations made, it may not be in their own short-term economic self-interest to pursue this line of thinking.)