Concluding Remarks at the Workshop on Monetary Policy in Emerging Markets

Since the inception of the international investment law system, investment promotion and protection have been the raison d’être of investment treaties and states have confined their policy space in order to attract foreign investment and protect their investors abroad. Languishing in relative obscurity until recently, the right to regulate has gradually come to the spotlight as a key component of negotiations on new generation investment agreements around the globe. States and regional organisations, including, notably, the European Union and the United States, have started to examine ways in which to safeguard their regulatory power and guide – and delimit – the interpretive power of arbitral tribunals, by reserving their right to pursue specific public policy objectives. The monograph explores the status quo of the right to regulate, in order to offer an appraisal and a reference tool for treatymakers, thus contributing to a better understanding of the concept and the broader discourse on how to enhance the investment law system’s legitimacy.

The Monetary Theory of the Lombard Enlightenment. The relationship. between economic arrangements and administrative decisions is at the core of the contributions of the Lombard economists of the eighteenth century, and it is also the main focus of this essay. Here, we wish to emphasize the importance of the history of ideas and of the history of facts in view of theory formulation and policy proposal within a framework of political economy. Theory must serve, together with history, to the governance of institutions aimed at the orderly working of economies and markets. The relationship. between economics and administration is at the root of the Milanese discussions on monetary policy that took place in the 1760s, and to which both Cesare Beccaria and Pietro Verri contributed. The interest of these discussions is twofold. On the one hand, as John Hicks pointed out, monetary disturbances throw light on the nature of money and on the problems monetary theory must address in moving from one context to another. On the other hand, monetary disturbances are important in highlighting the linkages between monetary theory and the governance of money in specific historical contexts. The writings of the Lombard Enlightenment economists are a case in point. For the Milanese monetary controversy highlights important theoretical issues concerning the governance of ‘imaginary money’, while also emphasizing the specific features of a context characterized by the integration between monetary and physical transfers on the international, and particularly European, scale. This controversy calls attention to monetary disturbances as triggers of change in monetary theory, but it also calls attention to the role of historical and institutional context in determining whether a given monetary policy may be effective or not. Monetary crises may trigger important developments in theory. At the same time, the crises highlight the objective character of structural conditions, which cannot be either unwillingly disregarded or deliberately violated. It is the task of the political economist to identify ‘a correct set of “economic laws” through the analysis of phenomena’, and outline on their basis ‘civil laws for the governance of the economy’(Quadrio Curzio). Section one of this essay (‘Monetary Disorders and Monetary Theory: A Premise’) outlines a conceptual framework for discussing the relationship. between theory, policy and historical context. Section Two (‘Economic Laws and Civil Laws’) discusses the monetary contributions of Cesare Beccaria and Pietro Verri and investigates the link between the structural properties of that ‘very delicate and complex device’ (Einaudi) that is the specific matter of monetary policy, and the civil or administrative laws and governmental decisions though which monetary policy comes into effect. Section Three (‘Monetary Theory and the Fundamental Ideas of Political Economy’) examines the links between the structure of economic systems as systems of interdependence among productive sectors and the structure of monetary systems as ‘systems of governance’ of that interdependence. Section Four (‘The Problem of “Debasement”; Monetary Disturbance and Real Standards’) focuses on the monetary controversy that triggered Beccaria’s and Verri’s contributions, and examines their attempt to identify a real standard for determining the relative value of the different currencies used for transactions on European markets. Section Five (‘Political Economy, Monetary Systems and the Practice of Monetary Policy’) considers possible developments of Beccaria’s and Verri’s contributions for what concerns the distinction between money as standard of measurement and money as means of payment. Section Six (‘Concluding Remarks’) draws the essay to close by discussing the integration between general principles of political economy and specific characteristics of ‘local’ context to be found in the monetary discussions of the Lombard Enlightenment.

This conference addressed some fundamental and long-standing problems in monetary policy. A discussion of these issues between policymakers and academic researchers is always important, both to improve the conduct of monetary policy and for the advancement of knowledge. In this conference, the discussion has been particularly fruitful and exciting; I am grateful to the Bank of Japan for having made this possible, and for having given me the opportunity to take part in it. My task is daunting, however. It is impossible to completely and adequately summarize the many ideas and insights that emerged over the course of two full days, about many aspects of monetary policy. Therefore, I do not even attempt to provide an exhaustive summary. Instead, I organize my concluding remarks around a number of questions that repeatedly came up in the discussion and in the contributions. I then try to summarize the consensus answer, or to identify the nature of the disagreement or the extent to which the question remains open.

Japan’s encounter with deflation and near‐zero‐interest short‐term interest rates in the 1990s led to a surge in research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy around the end of that decade. Based on model simulations, the literature at that time identified a number of key implications of the ZLB (see Orphanides and Wieland [2000], Reifschneider and Williams [2000, 2002], Eggertsson and Woodford [2003], and references therein). First, with low inflation targets of the kind followed by many central banks, the ZLB will frequently be a binding constraint on monetary policy. That is, Japan’s example is not an outlier but rather a harbinger for the future. Second, at inflation targets of 1% or lower, lowering the inflation target comes at a cost of higher variability of output and inflation, although the effects on inflation variability are relatively small. This analysis provides an argument for maintaining a positive inflation target cushion above 1%. Third, in rare instances of severe prolonged recessions accompanied by deflation, standard open market operations will be insufficient to bring the inflation rate back to target, andalternative sources of stimulus to the economy, such as fiscal policy, will be needed. Fourth, central banks can significantly reduce the effects of the ZLB onmacroeconomic stability by modifying their policy actions and communication to the public when the ZLB threatens to constrain policy. Specifically, policies that cut rates aggressively when deflation is a risk and promise to temporarily target a higher rate of inflation following episodes where the ZLB binds were found to greatly reduce the effects of the ZLB in model simulations. In the decade since this researchwas initiated, the ZLB has gone froma theoretical issue applying to Japan to one that plagues many industrialized economies. Indeed, an era of overwhelming confidence in monetary policy’s power to tame the business cycle while delivering low and stable inflation has been replaced by fears that the global economy could

In the Concluding Remarks that Paolo Baffi - Governor of Bank of Italy - read on 31 May 1979, he stressed that “the actions of central banks are no longer cloaked in silence, and perhaps never will be again. Whereas in the past silence was seen as a guarantee of independence, today this is achieved by giving an explicit account of one’s actions”. In the Governor’s words it is evident and illuminating the precognition of the increasing importance of the links between monetary policy, central bank governance and communication in influencing the overall effectiveness of the monetary action in the modern economies.

Contents: PART I: FRAMEWORKS FOR MONETARY POLICY 1. Monetary Policy Challenges for Emerging Market Economies Gill Hammond, Ravi Kanbur and Eswar Prasad 2. The Pursuit of Monetary and Financial Stability in Emerging Market Economies Bandid Nijathaworn and Piti Disyatat 3. Implementation of Inflation Targets in Emerging Markets Jose De Gregorio 4. Whatever Became of the Monetary Aggregates? Charles Goodhart 5. Fear of Appreciation: Exchange Rate Policy as a Development Strategy Eduardo Levy-Yeyati and Federico Sturzenegger 6. Aid Reversals, Credibility, and Macroeconomic Policy Edward Buffie, Christopher Adam, Stephen O'Connell and Catherine Pattillo PART II: COUNTRY EXPERIENCES 7. The Nexus between Monetary and Financial Stability: The Experience of Selected Asian Economies Sukudhew Singh 8. A Framework for Independent Monetary Policy in China Marvin Goodfriend and Eswar Prasad 9. Monetary Policy Transmission in India Rakesh Mohan and Michael Patra 10. Inflation Targeting and Exchange Rate: Notes on Brazil's Experience Daniela Silva Pires, Paulo Vieira da Cunha and Wenersamy Ramos de Alcantara 11. Czech Experience with Inflation Targeting Ludek Niedermayer 12. Monetary and Fiscal Policy Mix in Serbia: 2002-2007 Diana Dragutinovic 13. Aid Volatility, Monetary Policy Rules and the Capital Account in African Economies Christopher Adam, Stephen O'Connell and Edward Buffie 14. Regional Asymmetries in the Impact of Monetary Policy on Prices: Evidence from Africa David Fielding 15. Monetary Policy and Inflation Modeling in a More Open Economy in South Africa Janine Aron and John Muellbauer 16. Inflation Management and Monetary Policy Formulation in Ghana Nii Kwaku Sowa and Philip Abradu-Otoo 17. Monetary Policy in Zambia: Experience and Challenges Denny Kalyalya

Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low— suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. 1 This, in turn, can raise aggregate demand by stimulating interest

Macroeconomic Policy Beyond Brexit

by Anatoliy Kinakh, Prime Minister ofUkraine After a deep and long-lasting recession, the Ukrainian economy has for the past two years demonstrated some very positive dynamics in its quantitative development indicators. This is essentially the result of reforms, which still require to be consolidated in order to engage the factors and mechanisms capable of ensuring long-term qualitative and sustainable development in our economy. How do we ensure sustainable growth, and realise the improvements in the main macroeconomic indicators together with serious and complex improvements at the micro-level, which would allow us to achieve the urgently needed shifts in the social sphere? These actual problems are the main priorities of macroeconomic policy. Furthermore, the search for solutions to these problems of our transitional economy requires profound scientific analysis. The following presentations made at the Conference on "Factors of Economic Growth in Ukraine" are serious scientific contributions by prominent economists in this field

Crises in Economic Thought, Secular Stagnation, and Future Economic Research

Monetary policy is the macroeconomic policy that allows central banks to influence the economy. It involves managing the money supply and interest rates to address macroeconomic challenges such as inflation, consumption, growth and liquidity. Historically, for a long time, the task of monetary policy was limited to controlling the exchange rate, which in turn was fixed (at the beginning of the 20th century on the gold standard) for the purposes of promoting international trade. Eventually such a policy contributed to the Great Depression of the 1930s. After the depression, governments prioritized employment. The central banks have changed their direction based on the relationship between unemployment and inflation, known as the Phillips curve. They believed in the link between unemployment and inflation stability, which is why they decided to use monetary policy (putting money into the economy) to increase total demand and maintain low unemployment. However, this was a misguided decision that led to stagflation in the 1970s and the addition of an oil embargo in 1973. Inflation rose from 5.5% to 12.2% in 1970-1979 and peaked in 1979 at 13.3%. Over the past few decades, central banks have developed a new management technique called «inflation targeting» to control the growth of the overall price index. As part of this practice, central banks are publicizing targeted inflation rate and then, through monetary policy instruments, mainly by changing monetary policy interest rates, trying to bring factual inflation closer to the target. Given that the interest rate and the inflation rate are moving in opposite directions, the measures that the central bank should take by increasing or decreasing the interest rate are becoming more obvious and transparent. One of the biggest advantages of the inflation targeting regime is its transparency and ease of communication with the public, as the pre-determined targets allows the National Bank›s main goal to be precisely defined and form expectations on of monetary policy decisions. Since 2009, the monetary policy of the National Bank of Georgia has been inflation targeting. The inflation target is determined by the National Bank of Georgia and further approved by the Parliament. Since, 2018- 3% is medium term inflation target of National Bank of Georgia. The inflation targeting regime also has its challenges, the bigger these challenges are in developing countries. There are studies that prove that in some emerging countries, the inflation targeting regime does not work and other monetary policy regimes are more efficient. It should be noted that there are several studies on monetary policy and transmission mechanisms in Georgia. Researches made so far around the topic are based on early period data. Monetary policy in the current form with inflation targeting regime started in 2009 and in 2010 monetary policy instruments (refinancing loans, instruments) were introduced accordingly, there are no studies which cover in full the monetary policy rate, monetary policy instruments and their practical usage, path through effect on inflation and economy. It was important to analyze the current monetary policy, its effectiveness, to determine the impact of transmission mechanisms on the small open economy and business development. The study, conducted on 8 variables using VAR model, identified both significant and weak correlations of the variables outside and within the politics like GDP, inflation, refinancing rate, M3, exchange rate USD/GEL, exchange rate USD/TR and dummy factor, allowing to conclude, that through monetary policy channels and through the tools of the National Bank of Georgia, it is possible to have both direct and indirect (through inflation control) effects on both, economic development and price stability

The article analyzes the effectiveness of the NBU's monetary policy. During the period of independence, the National Bank never performed any of the functions stipulated by law. The main instruments of monetary and credit policy at the disposal of the central bank are not used as intended, and therefore do not ensure the performance of the functions entrusted to the National Bank of Ukraine, in particular: they do not ensure the stability of the hryvnia exchange rate, price stability, accelerated socio-economic development of the state and the adopted inflation level. The monetary and credit policy of the National Bank must be radically changed to ensure the implementation provisions of Art. 6 of the Law of Ukraine ‘On the National Bank of Ukraine'. The central bank's efforts must be coordinated with the government's efforts, and the central bank's monetary policy must be coordinated with the government's fiscal policy. In the paper, we propose to change the monetary policy instruments of the NBU in order to direct it to the support of the real sector of the economy and the stability of the exchange rate. The proposed changes provide for the establishment of refinancing rates up to 2%, placement of deposit certificates -2% (minus 2%). At the same time, it is necessary to make changes to the Tax Code of Ukraine regarding the introduction of progressive floating rates of taxation of the profit of financial institutions, limitation of the right to deduct losses from the tax base of financial institutions in certain cases. . . For the actual production of goods with a high added value, provide the reduction of the tax base for the part invested in production, and set the tax rate for the distributed part of the profit at the level of the personal income tax rate. Non- traditional methods of stimulating development are also proposed, in particular the purchase of government securities. The marginal value of government debt securities should be limited to 2-3% of GDP.

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Previous articleNext article FreeCommentBennett T. McCallumBennett T. McCallumCarnegie Mellon University and NBER Search for more articles by this author Carnegie Mellon University and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThis is an interesting and challenging paper, in which Atkeson and Kehoe put forth a very strong critique of current mainstream monetary policy analysis. Monetary economists have, of course, been rather pleased with the development of their subject over the past 10–15 years, current U.S. policy difficulties notwithstanding. Indeed, the tone of a prominent recent expository paper by my colleague, Marvin Goodfriend, is somewhat triumphal in spirit.1 The spirit of the Atkeson and Kehoe paper, by contrast, is conveyed by a recent publication of theirs, together with coauthor Fernando Alvarez, which bears the title “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is Wrong” (Alvarez, Atkeson, and Kehoe 2007). That paper focuses on exchange rate failures, whereas the current one stresses the term structure of interest rates, but the line of argument is basically the same.The title of the 2007 paper leads me rather naturally to ask myself what it is that I would say in answer to the implied question, “What important things do monetary economists really know—or at least believe—about monetary policy?” My own answer to that question would go along the following lines: (i) We believe that if the monetary authority keeps monetary policy expansionary for a substantial length of time, the main effect will be to generate a higher inflation rate than would have prevailed otherwise, with little or no overall effect on aggregate production and employment. (ii) Nominal interest rates will be higher, also, with real rates being affected very little. (iii) If, however, the monetary authority changes policy unexpectedly and abruptly in an expansionary direction, there will most likely be an expansion in aggregate output and employment—but it will be only temporary. (iv) If these changes are in the direction of tighter policy, the signs of the above‐mentioned effects will be reversed. (v) In particular, the monetary authority has the power to generate a recession, in which output and then the inflation rate will fall. (vi) The precise nature of the mechanism that generates the real effects of monetary policy changes of this type is not very well understood. Then, if my questioner had not wandered away in boredom, I would want to add something like the following: (vii) The foregoing points refer to an expansionary or contractionary monetary policy stance—loose or tight—but how is this measured? Well, a sustained high growth rate of the stock of base money will (under most institutional arrangements) be expansionary, but matters are a little less clear‐cut when the central bank actually carries out its policy by manipulating overnight interest rates. Nevertheless, there are ways in which we can characterize tighter versus looser policy in terms of interest rate rules by reference to the implied target inflation rate, the strength of responses to deviations from target, and so forth.Now, I suspect that Atkeson and Kehoe probably do not disagree with most of these statements as to what monetary economists know (or believe), even on a substantive basis.2 But their title of the current paper, as distinct from the 2007 item, refers to a need for a new approach to monetary policy analysis. So let us turn to a consideration of what today’s mainstream approach is. As it happens there is a short statement of that type, in a paper of mine, that gives the following description. The approach is one in which “the researcher specifies a quantitative macroeconomic model that is intended to be structural (invariant to policy changes) and consistent with both theory and data. Then, by stochastic simulation or analytical means, he determines how crucial variables (such as inflation and the output gap) behave on average under various alternative policy rules. Usually, rational expectations (RE) is assumed in both stages. Evaluation of the different outcomes can be accomplished by means of an optimal control exercise, or by reference to an explicit loss function, or left to the judgment (i.e., loss function) of the implied policymaker” (McCallum 2001, 258). Here, too, I doubt that Atkeson and Kehoe have any major disagreement with this general approach. What they do disagree with, if I understand at all, is the model that is typically used in recent work and taken to be structural.3In a sense my last statement could be regarded as merely quibbling over their title. But the point seems to be one of some importance: if Atkeson and Kehoe can generate an optimizing model that incorporates reliable, quantitative estimates reflecting time‐varying “risk” (i.e., state‐dependent variances and covariances) and endogenously explains inflation and output fluctuations, then monetary economists would presumably be happy to incorporate such features in their models—and would not consider this to reflect any basically new approach. Be that as it may, in what follows I will briefly review their featured empirical regularities, discuss issues concerning their suggested modeling strategy, and provide a brief conclusion.1See “How the World Achieved Consensus on Monetary Policy” (Goodfriend 2007).2They would probably grumble, justifiably, about the vagueness of point vii.3McCallum (2001, 258) goes on to say: “There is also considerable agreement about the general, broad structure of the macroeconomic model to be used.” Atkeson and Kehoe clearly would not share in this agreement.II. Empirical RegularitiesAtkeson and Kehoe begin, in Section I, with “four key regularities regarding the dynamics of interest rates and risk that we use to guide our construction” of a model and its pricing kernel. The first two pertain to a principal components analysis of a collection of interest rates, specifically, a 3‐month T‐bill rate and zero‐coupon yields on U.S. Treasury securities with k‐year maturities for $$k=1,$$ 2, …, 13. Time series observations are monthly over 1946.12–2007.12. The first regularity is that “the first principal component accounts for over 90% of the variance of the short rate [i.e., the 3‐month rate].” The second regularity is that “the second principal component is very similar to the yield spread between the short rate and the long [i.e., 13‐year] rate.” Having demonstrated these facts—and also that the first component is correlated even more strongly with the long rate—the authors henceforth use just the short and long rates.More substantively (and more questionably), the third and fourth regularities pertain to expected excess returns in the context of term structure and international exchange rate contexts. Specifically, movements in yield spreads and exchange rate premia are “associated with movements in risk.” The way in which these regularities might be regarded by some readers as questionable is that, in many studies, “risk” is operationally the name that is given to differentials in expected returns that the analyst’s model is not able to explain.Later in the paper, in Section V.A, Atkeson and Kehoe plot short‐rate and long‐rate time series for the United States over an extended period from 1836 through 2007. In addition, they include analogous plots for the United Kingdom, France, Germany, and the Netherlands. In all of these, the fluctuations of the long rate represent “a much smaller fraction of overall fluctuations in the short rate than they are in the postwar period.” Thus, they state: “A central question in the analysis of monetary policy at the secular level then is, What institutional changes led to this pattern?” In the preliminary version of this comment, I responded to a more pointed and strongly emphasized version of this query by stating that, to me, it is no surprise that expectations of future interest rates became unanchored during the post–World War II period, because, to again quote myself,[the] collapse of the Bretton Woods system created, for the first time in history, a situation in which the world’s leading central banks were responsible for conducting monetary policy without an externally imposed monetary standard (often termed a “nominal anchor”). Previously, central banks had normally operated under the constraint of some metallic standard (e.g., a gold or silver standard), with wartime departures being understood to be temporary, i.e., of limited duration. Some readers might not think of the Bretton Woods system as one incorporating a metallic standard, but by design it certainly was, since the values of all other currencies were pegged to the U.S. dollar and the latter was pegged to gold at $35 per ounce. (McCallum 1999, 175–76)All in all, it seems that there is no difficulty in understanding why an altered monetary policy regime generated different expectations regarding inflation and therefore future short interest rates in the post–World War II era. The variability in long rates during the 1960s developed as market participants began to see that the United States was not going to be bound by its commitment to maintain the $35 per ounce price of gold. Then the variability jumps up around the time of the Bretton Woods collapse in 1971—see Atkeson and Kehoe’s figures 6A–6E—and continues to rise into the Volcker disinflation that was painful (with extremely high nominal interest rates) but that ultimately succeeded in restoring some semblance of a nominal anchor.What about the return to stability that may have occurred around 1990? That year is, of course, the year in which the first central bank (New Zealand) officially adopted a monetary policy regime of “inflation targeting” (IT). At that time, this was taken to mean a policy whose only objective was a low and stable inflation rate. Since then, the IT term has come to be applied to regimes that give more weight to output/employment stabilization, but most monetary economists understand it as continuing to emphasize, as the primary goal, inflation control. So again the timing is about right for the possible recovery of anchored expectations that the first empirical regularity is said to reflect.To this general line of argument, Atkeson and Kehoe object: “But this answer is, at best, superficial. In the prewar era, countries chose to be on the gold standard most of the time and chose to leave it when it suited their purposes. Thus, the relevant questions are, rather, What deeper forces led agents to have confidence that their governments would choose stable policy over the long term? And what forces led them to lose this confidence after World War II? Only if we can quantitatively account for this history can we give advice on how to avoid another great inflation.”In this regard it must be said that I consider an explanation of the evolution of beliefs regarding the monetary standard, held by citizens of the United States, Great Britain, Germany, and so forth, to be somewhat beyond the scope of monetary policy analysts. To think about this issue, one must recognize that historically “the gold standard” required not just that the monetary authority would stand ready to exchange gold and currency at a specified rate but also that this rate should be unchanged “forever.” That arrangement made it such that severe inflation would not occur—even the major historical gold discoveries did not generate sustained inflation on the order of 10% per year—but it did generate more cyclical instability of real variables than we have had in the postwar era. Could policy of that type win popular support in today’s environment in the United States? If not, which would be my answer, then we need an entire unified social science to provide an explanation at “a deeper level.” And such an explanation—which would need to emphasize enormous developments in the media, extensions of suffrage, evolution of religious beliefs, attitudes toward the role of government, and so on—would not be of much help to central bankers. Let us turn then to monetary policy analysis considered more narrowly.III. Basic AnalysisThe heart of Atkeson and Kehoe’s paper is a recommended response to the third and fourth of the regularities mentioned above, that is, that measured excess returns on multiperiod bonds fluctuate strongly with yield spreads for bonds of different maturities and for international exchange rates. These regularities are translated by Atkeson and Kehoe into an argument that the consumption Euler equation, some version of which (often termed an expectational IS equation) is one basic ingredient of current macro‐monetary models, performs very poorly empirically. This is, of course, true for the simplest versions, but that problem has been widely recognized by monetary economists. A nice overview of empirical weaknesses of so‐called New Keynesian models was provided some years ago in a working paper by Richard Dennis (2003), which is briefly and nontechnically summarized in Dennis (2004). (The weaknesses discussed there relate to the Calvo‐style price adjustment relation, as well as the consumption Euler equation.) Dennis distinguishes between the bare‐bones “canonical model” and a “hybrid” version that adds habit formation in consumption behavior to the basic consumption‐saving relationship and also adds a somewhat dubious dependence on lagged inflation to the basic Calvo price adjustment relation. He recognizes, following Estrella and Fuhrer (2002), that “the problem with the canonical model is that the behavior of output, consumption, prices, and interest rates suggested by the model are fundamentally at odds with observed data” (Dennis 2004, 1). The hybrid model performs better, in terms of matching quarterly data, but “there are a number of areas where the hybrid model’s responses differ importantly from” impulse responses of an identified vector autoregression (VAR; Dennis 2004, 3).The point here is that monetary economists are quite aware that current models, even with elaborations of the type utilized by Christiano, Eichenbaum, and Evans (2005) or Smets and Wouters (2007), have empirical weaknesses, and they have been active in trying to eliminate these problems by improved specification. One pertinent and recent example concerns the discouraging results reported by Canzoneri, Cumby, and Diba (2007), that is, that inclusion of habit formation in consumption behavior unrealistically increases the variability of interest rates.4 Subsequent results by Collard and Dellas (2007) indicate, however, that this deterioration obtains when the household utility function is taken to be additively separable in consumption and leisure. If instead consumption and leisure enter the function in a Cobb‐Douglas manner, then inclusion of habit results in an improved—not worsened—match of the model’s interest rate variability to that of the data.I might also remark that Atkeson and Kehoe’s way of considering the empirical failure of the Euler equation seems questionable. Specifically, they discuss the relationship in a manner that would be appropriate if the role of this equation were to explain movements in nominal interest rates of various maturities. In fact, however, the role of this equation in standard monetary policy models is to explain consumption in response to (real) interest rates and expected future consumption (and, in habit specifications, lagged consumption). No mention of the adequacy or inadequacy of the standard model’s properties with regard to consumption is provided.5Be that as it may, it is essential to consider the analytical heart of Atkeson and Kehoe's paper, which is their presentation of “a simple model of the pricing kernel that is consistent with these [observed] dynamics” pertaining to interest rates. For the one‐period nominal interest rate, it in their notation, the pricing kernel mt+1 is an unobservable random variable that is generated by a stochastic process such that the interest rate it can be determined by a relation of the form $$i_{t}=-\mathrm{log}\,E_{t}\mathrm{exp}\,( m_{t+1}) .$$ Assuming conditional lognormality, then, we have (1)it=−Emt+1−0.5Vartmt+1. Except for lognormality, the content of their model for it is then the specification of the stochastic process generating mt+1. They take it to be (2)−mt+1=δ+z1t+σ1ε1t+1=1−λ2/2z2t+z2t0.5λε2t+1+σ3ε3t+1, where $$\varepsilon _{1t},$$ $$\varepsilon _{2t},$$ and $$\varepsilon _{3t}$$ are independent, standard normal, white‐noise innovations and where (3)z1t+1=z1t+σ1ε1t+1. (4)z2t+1=1−φθ+φz2t+z2t0.5σ2ε2t+1. These processes are chosen with an eye to their implications for the term structure via the relation (5)1=Etexpmt+1+pt+1k−1, which characterizes an absence of arbitrage possibilities for k‐period bonds with prices, $$p^{k-1}_{t+1}$$. From these prices the analyst can calculate term structure measures.Finally, Atkeson and Kehoe calibrate the model by assuming that $$\lambda =\sqrt{2}$$, $$\varphi =0.99,$$ and $$\sigma _{2}=0\mathrm{.}\,017$$. This specification suffices, they report, to generate interest rates of different maturities such that the term structure features long and short rates that possess properties that have the general characteristics found in their exploration of monthly data for rates of various maturities in the U.S. data.How does this model compare in specification with the standard three‐equation framework used in recent years to model one‐period interest rates, consumption (and/or output), and inflation by Clarida, Gali, and Gertler (1999), McCallum (2001), Woodford (2003, 238–47), and dozens of other monetary economists? That framework, as is well known, consists of (i) a consumption Euler equation (aka expectational IS relation), (ii) a price adjustment relation (usually of the Calvo variety), and (iii) a monetary policy rule that specifies adjustments of the one‐period nominal policy rate it to its determinants, which include the steady state real interest rate, the central bank’s inflation target, departures of inflation from target, and departures of output from its natural (flexible price) rate. (The lagged rate it‐1 is often included as well to represent smoothing.) This framework implicitly adopts the expectations theory of the term structure, which is known to be inconsistent with the data. Notable examples of larger models that include more variables and equations but that have the same basic underlying logic are provided by Christiano et al. (2005) and Smets and Wouters (2007).One aspect of the comparison is that the Atkeson‐Kehoe model, since it pertains to an “endowment economy,” implicitly assumes that price level adjustments are complete within each period so that output is always equal to its (exogenous) natural rate, flexible price value. Only a degenerate version of the Calvo equation component of the standard model is therefore present. That removes one endogenous variable, output/consumption. For some purposes, a flexible price model can be useful for monetary policy principles, as in Woodford (2003, chap. 2). But Atkeson and Kehoe also treat inflation as exogenous. Thus, there is no possibility remaining for conducting monetary policy analysis, and it is not determined by central bank behavior. Those features are consistent with their expressed view that the central bank “simply responds to exogenous changes in real risk—specifically, to exogenous changes in the conditional variance of the real pricing kernel—with the aim of maintaining inflation close to a target level.” But this seems highly unsatisfactory. It is probably true that a substantial portion of the meeting‐to‐meeting variations in the federal funds rate in the United States represents adjustments that are responses to changes in real rates that are brought about by changes in tastes, technology, shocks from abroad, and even perhaps some random behavioral errors by private agents. In fact, this is implied by much of the analysis that represents today’s mainstream monetary policy analysis—see, for example, Woodford (2003, and But the modeling approach suggested by Atkeson and Kehoe that the its for a random that is it no in a no is provided that their model would do a of matching data on much less two variables as endogenous and by central bank by a policy rule for a variable, the model is not in for monetary et al. (2007) paper is by Atkeson and and Kehoe to believe that standard have Euler equations that include no term reflecting and Kehoe are to say that the Euler equation specification in many monetary models does not well empirically. In addition, their specification of stochastic processes for the and variables that yield a pricing kernel that term structure features that the data in important ways is and They in that models in which conditional variances of returns are variable provide an possibility for improved model specification. This is not of course, and does not of inflation and output as exogenous or to a model that leads to their highly about the nature of monetary policy in the United States (and, other and currency is a of the monetary policy that term structure that pricing with time‐varying risk premia in models along with endogenous price and monetary policy rules. Some leading examples are provided by and and et al. (2007), and These have beyond Atkeson and Kehoe in to models that the term structure regularities maintaining a framework for monetary policy analysis. the approach time‐varying conditional is not the only one of as the Collard and Dellas (2007) example In I by of the Atkeson and Kehoe critique of some features of today’s New Keynesian monetary policy models, but I their current to be in essential their of U.S. monetary policy to be and their critique of current monetary policy analysis to be a brief see Atkeson, and 2007. “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is and in Cumby, and T. 2007. and of Monetary in Eichenbaum, and and the of a to Monetary of in Gali, and of Monetary A New Keynesian of in and 2007. and Monetary paper, of in Keynesian Empirical of in Keynesian and to the of in and of a of in and 2007. with of in and McCallum and the of of Monetary in 2007. “How the World Achieved Consensus on Monetary of in T. in Monetary Policy The of and of in of in Monetary Policy to and in 2007. and Monetary paper, of University of in and in and 2007. and in A in and of a of Monetary University in Previous articleNext article by NBER by the of on this by the of no articles this

Monetary policy in a world of radical uncertainty