G

1
Central 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

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Cast 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)

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Monetary 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.

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Friedman (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.

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So 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.

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Money 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.

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Our 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.

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1. 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!

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Monetary 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.

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Monetary 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.

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Why cross-check with a monetary (trend) measure?

• Why Lucas talks about trends
• (Benati 2005)

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Deriving 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

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The 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).

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Strategy 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.

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Strategy 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.

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Strategy 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.

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Policy objective and optimal interest rate
policies

• Policy objective
• K-Model optimal policy under uncertainty

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Policy 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.

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The Models
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The Parameters
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A Simple New-Keynesian Model

• Following Clarida, Gali, Gertler (1999)
• (1) Output gap
• (2) Phillips
• (3) IS
• Note superscript e Et

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NK Model Includes Persistent Shocks

• (5) Persistent shocks

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Noise and Misperceptions in NK Model

• (9) Noise Actual shocks differ from perception

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U.S. output gap misperceptions
Orphanides, The quest for prosperity without
inflation, Journal of Monetary Economics, 2003.
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The Bundesbanks output gap misperceptions
Gerberding, Seitz, Worms, How the Bundesbank
really conducted policy, North American Journal
of Economics and Finance, 2005.
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2. 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.
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Money 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.

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NK optimal interest rate with misperception

• Persistent misperception implies that interest
  rates are set too low or too high for a sustained
  period of time.

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K-Model US-misperceptions
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K-Model US misperceptions Actual and perceived
output gap
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NK-Model Bundesbank misperceptions
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Trend measures K/NK-US/DE 1000 draws
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3. Misperceptions and cross-checking

• K-Model US misperception with cross-checking

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NK model Bundesbank misperceptions with
cross-checking
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1000 draws K/NK-US/DE with cross-checking
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4. 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).

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Sustained velocity shift of 2 when the central
bank never revises estimates
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Sustained velocity shift and cross-checking when
central bank learns
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Conclusions

• 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.