JournalofPolicyModeling42(2020)153–172
ScienceDirect
Policy
implications
of
the
Lucas
Critique
empirically
tested
along
the
global
financial
crisis
Amira
Karimova
a,
Esra
Simsek
b,
Mehmet
Orhan
c,∗aOntarioMinistryofLabour,Ontario,Canada
bDepartmentofEconomics,IstanbulBilgiUniversity,34060Istanbul,Turkey cDepartmentofEconomics,TheUniversityoftheWestIndiesatMona,Mona,Jamaica
Received12September2018;receivedinrevisedform3May2019;accepted20June2019 Availableonline26July2019
Abstract
Thisstudyisthefirstattempttofacilitatethesubstantialchangeinpost-crisismonetarypolicyofthe FedtotestthevalidityofLucasCritiquetowardexploringimplicationsofsuchchangesforpolicymaking. Globalfinancialcrisis,askingforfundamentalregimealterationspresentedaninvaluableopportunityto testtheempiricalvalidityofLucasCritique.WemakeuseofquarterlyUSdataover1990–2015totestfor superexogeneity,therejectionofwhichlendssupporttoLucasCritique.Wedefinethemarginalmodels forwealth,GDPandTreasuryBillratetoconstruct theconditionalmodelofmoneydemandfollowing
Hendry(1988).OurresultsrejectsuperexogeneityofthepoliciesandreportthesupportforLucasCritique. Wediscussaboutthedetailsandconsequencesofthemonetarypolicyfollowedtosuggestargumentsto prolongingdebatesonpolicydiscussions.
©2019TheSocietyforPolicyModeling.PublishedbyElsevierInc.Allrightsreserved.
JELclassification: C22;C52;E41;E42;E52;E58
Keywords: LucasCritique;Monetarypolicy;Superexogeneity;Invariance;Rationalexpectations
∗Correspondingauthor.
E-mailaddresses:amira.karimova@ontario.ca(A.Karimova),esraqsimsek@gmail.com(E.Simsek),
mehmet.orhan@uwimona.edu.jm(M.Orhan).
https://doi.org/10.1016/j.jpolmod.2019.06.003
1. Introductionandresearchbackground
1.1. LucasCritique
LucasCritique(LC),withitsempiricalvaliditystillunderdebatemorethanfourdecadesafter itsinception,hasseriouspolicyimplications.Economicagents,firmsandinstitutionsinany coun-tryundertheadministrationoffinancialandfiscalauthoritiesaredirectlyinfluencedfrompolicy objectivesandregimechanges.Theimpactofpolicychangesonnominalandrealmacroeconomic indicatorsiscriticalandcrucial.Yet,thereisstillharshdebateontheconsequencesofmonetary andfiscalregimechanges.Inthisregard,critiqueposedby1995NobelLaureateRobertE.Lucas isamilestonetoassesstheresultsofpolicychangesandpresentsbeneficialandeffectiveclues aboutpolicydesign.
Lucasarguesthatmacroeconometricmodelsthatdonothandleoptimizingbehaviorofrational agentsatpolicychangesaresubjecttofailure.Assumingthattheagentsareforwardlooking,their economicdecisionswilldependpartlyonfutureactionsofthepolicymakers.Lucassuggeststhat thelinkagebetweentheregimechangesbypolicymakersinthefutureandforecastsof agents handlingthesechangesshouldbeincludedineconometricmodels.Lucas’scontributionto pol-icyevaluationwasrevolutionarysincehehasdemonstratedthatconventionalbackward-looking modelsignoredtheformationofexpectationswhichisthekeydeterminantofagent’sbehavior incaseofapolicyregimechange.LCdependsontheformationofexpectationssubstantially.By hiscritique,Lucasmadeitclearthatpoliciescannotbeevaluatedwithintheclassicaltheory,and conventionalmacroeconometricmodelscannotbeused toinvestigatepolicychangessincethe structuralparametersdochangeaspolicydoes.
Thecritiquecanbesummarizedbythemostquotedexpressionofitas“Giventhatthestructure ofaneconometricmodelconsistsofoptimaldecisionrulesofeconomicagents,andthatoptimal decisionrulesvarysystematicallywithchangesinthestructureofseriesrelevanttothedecision maker,itfollowsthatanychangeinpolicywillsystematicallyalterthestructureofeconometric models.”Implicitlystatedinthisexpressionisthattheagents’optimizationproblemscompriseof parametersusedinpolicyrules.Tobemorespecific,followingthenotationinEricssonandIrons (1995),assumethattheeconomyischaracterizedbythedecisionruleoptimizedbytheagents, F(.),andthepolicyreactionfunction,G(.):
yt+1 =F(yt,xt,θ,εt)
xt =G(yt,xt−1,λ,ηt)
whereytistheendogenousvariable,xtistheexogenousvariable,εtandηtareshocksattimet, andθandλaretheparametersofthecorrespondingfunctions.TheagentoptimizesFandhasto takecareofparametersinGsinceθmaydependonλandthuswhenλchangesduetoaregime shift,θchangesdirectly.ThecritiqueposedbyLucasisontheoreticalgroundandisindeepneed ofempiricalsupport.
Lucasinhisoriginal1976paperexemplifiesthisprocesswithFriedman’sconsumption func-tion, taxation,investmentdemand, andPhillips curve.Lucashadcriticizedthe facilitationof modelstoestimatetheimpactofalternativepoliciesarguingthattheparametersincludedinthe modelsarenotinvarianttoshiftsinpolicy.Incaseofachangeinpolicy,therationalagentsmodify theirexpectationsandnewdecisionrulesarefixed.Thatiswhymodelsbasedonthedecisionrules varyduetopolicyshiftsandmodelswithoutthisfeatureareinferior.Theresponseof
macroe-conomiststoLucasCritiquewastheintroductionof DynamicStochastic GeneralEquilibrium (DSGE)Modelswhereparameterscorresponding topreferencesandtechnologyarepreserved unchangedevenifthereisashiftofthepolicyregimewiththeinevitableassumptionofcorrect DSGEmodelspecification.InatypicalDSGEmodel,variablesrepresentingtechnologyand pref-erencesdonotvaryandarenotsubjecttochangesinpolicyregimes.Oncethestructuralmodel iscorrectlyspecified,estimationofparametersbelongingtothesevariableswillnotbebiased. ThisveryfeatureoftheDSGEmodelsmakethemfreefromLC.
1.2. Rationalexpectations
Theexpectationsoftheagentsareattheheartofthecritique.LCfocusesonhowparameters oftheeconometricmodelsentertheoptimizationfunctionsoftheeconomicagents.Thatis,the parametersthatpolicymakerssetbychangingthepolicyregimeshavetoentertheoptimization problemsof the agents.Aspolicyregimeschange, thenature andthusthepreferencesof the agents donotchange buttheirexpectations do.Theexpectations areaddressedtobeforward instead ofbackward-lookingafterthe popularizationofthe rationalexpectations revolutionin macroeconomicswhichbuildontheearlierpaperofMuth(1961)thatmadeuseoftheadaptive expectations byFriedman(1956)andCagan(1956).Theimplicationsofrationalexpectations onpolicyanalysisareessential,fundamentalandremarkable.Themainfindingsoftheimpact ofrationalexpectationshypothesisonpolicyregimechangesarebyBarro(1976),Kydlandand Prescott(1977),Lucas(1976),Sargent,Fand,andGoldfeld(1973),SargentandWallace(1975). The rationalexpectations hypothesisassumethat the individualsknowthe structureof the economy andpast values of all variablestherein. In addition,the agents are assumed not to makesystematicerrorssincetheinformationsetavailableincludespasterrors.Shiller(1978),
Fischer(1980),Begg(1982),andSheffrin(1996)aretheinitialreferencestorational expecta-tionswhileearlierstudiesofrationalexpectationshypothesisonmonetarypolicyincludeSargent (1977),Sargentetal.(1973),LucasandSargent(1981),andLucasandPrescott(1971).Themain themeofthedebatewaspolicyineffectivenessthatnecessitatesnoeffectofanticipatedsystematic monetary policyonmeanandvarianceofoutput.Thatis,systematicmonetarypolicychanges cannothaverealeffectsontheeconomy.TheearlyversionsbyFriedman(1968)statedthatoutput wasindependentofmonetarypolicyinthelongrun.ThepaperbySargentandWallace(1975)
concludedthesameforshortrun.Theassumptionofagent’soptimizationbasedonrational expec-tationsissostrongtoeliminatesystematicforecasterrorsassociatedwithadaptive,regressive, extrapolativeorothertypesofexpectations.
Althoughrationalexpectationshypothesisdeservesitsreputationsinceitaddressesthesolution toasetofdebates,ithasintroduceditsownproblemsandshortcomings.Themaincriticismis theso-calledconstructionofthetruestructureoftheeconomybyindividualswhodonotknow enoughabouttheeconomyandmodelingmathematicswhilewiseeconomistsdebateonmainand simpleissues.Besides,“Howdotheagentsrationalizeexpectationsandlearnfromthemistakes togetridofsystematicforecasterrors?”isanotherkeyquestiontobeansweredsatisfactorily.
AremarkablefundamentalproblemwiththeLCistime-inconsistencystressedbytheseminal workofKydlandandPrescott(1977).Theoptimalpolicieswithforward-lookingexpectations maybecomesub-optimalthroughtime,knownastime-inconsistencyordynamicinconsistency. Thatis,exanteoptimalpoliciesmaybecomesub-optimalexpost.LCitselfwascriticizedbymany others,asHendry(2002)indicated“...thecritiquehasbeencriticizedinturnbymanyauthors, including Gordon(1976),Sims(1986),Sims,Goldfeld,andSachs(1982)andHendry(1988), andmostrecentlybySalmonandMarcellino(2001),whoshowtheinternally-inconsistentuseof
‘rationality’inLucas’sanalysis.Thereisalsoscantevidenceofitsoperationempirically(see,in particular,Ericsson&Irons1995)”.Inaddition,therehavebeenmanyothersuchcriticismsafter early2000s.SeeSmith(2009)foralistofargumentsagainstLC.AlthoughtheLCisgenerally acceptedandintegratedtomainstreammacroeconomictheory,itdidnotpassrigorousempirical testtoassertitsvalidity.
Onthe otherhand,Mishkin(1995)indicates thatthe LCwasrevolutionaryandunderlines theroleofexpectationsas:“Policymakersnowrecognizetheimportanceofexpectationstothe outcomeofparticularpoliciesbecauseoftherationalexpectationsrevolution:beforetheadvent ofrationalexpectations,expectationsweretypicallyignoredbypolicymakerswhenconducting policyanalysis”But,thereislackofguidancetopolicymakersasindicatedbySims(2007)as“...I alsocriticizedtheacademiceconometricandmacroeconomicliterature,whichtooknointerest inpolicymodelingandhadlittleguidancetoofferpolicymodelers.”
1.3. Globalfinancialcrisisandregimechangeinmonetarypolicy
ThereareseveralchallengesagainsttestingtheLCempiricallyoneofwhichisaddressinga fundamentalchangeinpolicyregimethatisfortunatelyprovidedtousbytheGlobalFinancial Crisis(GFC),althoughweareextremelyupsettoexperiencetheconsequencesofit.The2008 financialcrisishadenormouseffectsontheglobaleconomyandposedobjectionstotraditional policymaking.Theso-calledcredittsunami(byAlanGreenspan)ofthecentury,inceptedbythe mortgagemarkets,startedhittingthefinancialmarketsandthus,institutionsinJune2007.Asa resultofthe initialdevastating strikesof thehugewaves,oneofthelargestUSfirmsthathad beenamainpillarofthe financialsystemsince1850,LehmanBrothers,filedforbankruptcy, aswellastheAmericanInternationalGroup(AIG),agiantinsuranceconglomerate.Thesetwo inadditiontomanysimilarothers,triggeredthefearsthatmanyinstitutionswouldbesuffering fromsubstantiallossesduetounpaidborrowingsthatwouldthreatentheirsolvency.Thepanic spreadtorealmarketsveryshortly.Thesewerereflectedtothestatistics;intheUS,the18-month recessionbetween2007and2009wasthelongestrecordedpostWWII.Itledto6.3%decline inemploymentand5.1%fallinoutput.Stockpricesfellby50%fromOctober2007toMarch 2009(“RecessioninPerspective”/FederalReserveBankofMinneapolis).Tsunamireachingthe otherpartsoftheglobethroughfinancialandtradechannelssoon,decreasedtheBalticDryIndex, underliningshippingvolumeandthusinternationaltrade,by50%inOctober2008.Japanand Korea,forinstance,had31%and26%declinesintheirindustrialoutputfromJanuary2008to January2009(Alzaabi,2013).Theglobalfinancialcrisisinits“GreatRecession”stagemarked theworsteconomiccontractionsinceWWII(Verick&Islam,2010).Mishkin(2009)indicated that thiswasthe worst financialcrisisthat the UnitedStateshas experiencedsincethe Great Depression.FacingtheworstfinancialcrisiseversincetheGreatDepressiontheFederalReserve hadaggressivelyloweredthefederalfundsratetargetfrom5.25%inSeptember2007to0to0.25% inDecember2008(Mishkin,2009).Asanattempttoalleviatethedestructiveconsequencesof thecrisis,whenObama’stermattheWhiteHousestartedin2009,hesignedthefiscalstimulus package toincrease federal government spendingby about $499billion andreduce taxes by around$288billion.Butmanagingthedetrimentalinfluenceofthecrisiswasextremelycomplex andbeyondsuchvoluminousfiscalpolicytools.
TheformerpresidentoftheECB,Jean-ClaudeTrichetindicatedthatthedefiningcharacteristic of the globalfinancial crisishadbeen soperplexingtoask for non-standardmonetary policy measures.Althoughthefinancialmarketsoftheglobeweresomehowubiquitous,theapproaches bythecentralbanksweredifferentdesignedforpeculiareconomiesandtheirstructuresranging
fromenhancedcreditsupportandcrediteasingtoquantitativeeasingandinterventionsinforeign exchange andsecurities markets.Besides, Fahr, Motto, Rostagno,Smets, andTristani(2011)
state“Theinitialturmoilandthesubsequentcrisisthatsweptthroughfinancialmarketsoverthe pastthreeyearshaveposedunprecedentedchallengesforcentralbanks.Theirpolicyresponses havebeenequallyunprecedentedandhaveinvolvednon-standardmeasures,i.e.actionsthatgo beyondtheusualchangesina“policy”interestrate.”Theyreasontheuseofunprecedented non-standardmonetarypolicyasthecentralbanksresponsibilitytopreventliquidityproblemsturning intosolvencyproblemswithaneventualbreakdownofthemonetarytransmissionmechanism.In addition,malfunctioninginterbankandotherfinancialmarketscalleduponcentralbankstotake onamoreactivefinancialintermediationrole.
Therewasurgentneedforaccommodativepoliciesofthemonetaryauthorities.AsMishkin (2011b)mentioned,thecontractionaryshockfromthefinancialcrisiswassoseverethatit over-whelmed theability of conventional monetary policy tocounteractit. Oneof the remarkable changesinvalidatingunconventionalmonetarypolicyhasbeentheQuantitativeEasing(QE) pro-gramadministeredbytheUSafterthecrisis,andfollowedbyseveralothercentralbanks.Thereis amountingbodyofrecentresearchonQEanditseffects(El-Shagi&Giesen,2013;Karagiannis, Panagopoulos,&Vlamis,2010;Mishkin,2011b;Rogoff,2017;Taylor,2014)andalmostallof them agreeonthe factthat QEwas,although riskyandnot desirable,bestpossibleoption to respondtotheongoingandfuturecontractionaryshockstotheeconomy.Intheprocessof imple-mentingQEpolicies,theFED’sbalancesheetdramaticallyexpandedfromaround$700billion in2008to$2.1trillioninJune2010,withmostoftheincreasesabsorbedbythebankingsystem asexcessreserves(Bernanke,2012).AndaccordingtoCNBC,theFed’stotalassetsinitsbalance sheetballooned from$900billionto$4.5 trillionbetween2008and2015(https://www.cnbc. com/2017/11/24/the-fed-launched-qe-nine-years-ago–these-four-charts-show-its-impact.htmlas of8Nov2018).
QE being applied practically atthe sametime commenced re-consideration of traditional monetarypolicy-makingwhichmayleadtoshedlightontheperplexingdebateoftheLC.Lucas (1976)arguesthatpolicyshiftsand/orstructuralchangesoftheexpectation-generatingmechanism leadtounstableeconometricmodels,sincesuchchangeswillalteractualstructuralparameters andtheestimatedcoefficientsinthemodel.TheQEasanagreeduponpolicyalterationresultsin theexpectationmodificationofeconomicagentsaswellasinstitutions.Inordertobeaneffective policytool,parametersoftheeconometricmodelmustbeinvarianttothesechanges.Theroleof theLChasbecomeveryimportantinevaluatingandanalyzingtheimplicationsofthepolicies undertakenafterthecrisisbecauseitmayhaveapowerfulinfluenceindecreasingtheapplication of thestandardmonetary modelsforthe policyanalysis.Applicabilityofthe LC,alsoknown asthevalidityof“deepstructuralparameters”(Fair,1987)issignificanttoaccuratelyassessthe futureeffectsoftheconsequentpolicyshiftsoneconomicactivityandagents’expectationsthat areassumedtobe“rational”.
1.4. Mainmotivation
TheempiricaltestingoftheLCisneverfoundsatisfactory.AsMalinvaud(1997)underlined “Indeed the small illustrative modelspresented byLucasandothers, showed nomorethan a possibilityandwereinnowaytestedastotheirempiricalvalidity.”Hecontinuedhiscriticism statingthat“...neitherLucasnortheNewClassicalmacroeconomistshadtriedtotesttheempirical validityoftheCritique:Atthetime,manymacroeconomists,especially[me],werenotconvinced
ofthescopeof[theLucasCritique],althoughtheyrecognizedthecorrectnessoftheremarkthat inspiredit.”
LucasandSargent(1981),intheirfamous“AfterKeynesianMacroeconomics”,indicate“Yet thequestionofwhetheraparticularmodelisstructuralisanempirical,notatheoreticalone.” Lateron,whenintroducinghiscollectedworksinStudiesinBusinessCycleTheory,Lucasand Sargent(1981)arguesagain:“...thispresumption[aboutpolicy-invariance]seemsasoundone tome,butitmustbedefendedonempirical,notlogicalgrounds,andthenatureofsuchadefense presumablywouldvarywiththeparticularapplicationonehasinmind.”
DespitealargeamountofresearchontheLC,thereisasurprisinglackofempiricalstudyon theissueoftestingtheempiricalvalidityofcritiqueintheliterature.1Thereasonsarevarious, such as thescarcity of observationalperiod attributedtofundamentalchangeinpolicy, small samples, andessentially,on top of whichis the absence of generallyaccepted methodology. Unfortunately,neither Lucasnor his immediate companions as well as his followers did not introducethemethodologytotesttheempiricalrelevanceofthetheory.Inlateryears,Engleand Hendry(1993)introducedtheconceptofsuperexogeneity,whichhasappearedtobeaneffective tooltotesttheempiricalrelevanceoftheLucasCritique.Subsequentpapers(Ericsson&Irons, 1995; Lindé, 2001) have demonstratedhow thisconcept canbe applied tocheck for policy invarianceineconometricmodels.Inthisway,superexogeneityhasbeenlargelyperformedto testtheeffectsofregimeshiftsinmonetary,exchangerate,consumptionandsavingsratebehavior (Karunaratne,1996).TheworksbyBoug(1999),FaveroandHendry(1992),EricssonandIrons (1995),andLubikandSurico(2010)highlighttheimportanceoftheuseofthesuperexogeneity testandconsideritasthemainempiricaltooltoassessLCvalidityafterthepolicyshifts.
Therearefavorablereasonsbehindusingsuperexogeneitytotestfor thevalidityofLC.As
Engle andHendry(1993) underline,someproblematic issues arise whenthe traditional tests intheliterature areused inordertofind therelevanceof theparameterstability withlackof guidanceon exactdatesandnumbers ofbreaks.The entiretestis misguidingwhen incorrect days areselected fortestingthe existence ofthe structuralbreak (Engle&Hendry,1993).In suchcases,testingforexogeneitywithitsthreedifferentversionsispreferable.Intheliterature threeversionsofexogeneityaredefined:Weakexogeneityisemployedforestimationpurposes, strongexogeneityisrequiredforforecasting,andsuperexogeneity(Superexogeneity)isfacilitated forpolicyanalysis.Althoughthesuperexogeneitytesthasbeenusedtocheckfortheeffectsof regimeshiftsinmonetary,exchangerate,consumptionandtradepolicies,thereisnoattempton itsapplicationwithQEintheliterature
In the contextof theseimportant policyquestions, the present period offers an invaluable opportunity totest the validity of LC empirically toward suggestions on policy design.This studyappliessuperexogeneitytest(Engle&Hendry,1993)todetecttherelevanceoftheLCin modelingthedemandformoneyintheU.S.afterthethreeQEattempts.Therelatedliterature recommendsthattheLCshouldbeassessedinthecontextofeconomicmodelsthatwoulddeal explicitlywithexpectations, suchas themoney demandfunctionused inthispaper(Engle& Hendry,1993;Hurn&Muscatelli,1992).Wealsoprovidepolicydiscussionsthatshedlighton thefragilityofconventionalmodelstocaptureexistinginformationandprovide correctpolicy implicationsintheenvironmentofmajorshiftssuchasQE.Aspertheconclusionoftheempirical testingof superexogeneity, rejection over the sample periodindicates that the parametersare variant/sensitivetothepolicychangesandimpliesthattheLCisrelevant.
Empiricalstudiesmakinguseofsuperexogeneityintheliteraturearescarceandstudiesbased onsuperexogeneitymethodologytotesttheLCinmonetarymodels,andalmostallexistingpapers areoutdated.OneoftherarestudiesisbyHurnandMuscatelli(1992)whofoundthattheLCmay notberelevantinthecaseofthedemandformoney(M4)intheUK.OtherssuchasKarunaratne (1996), Valadkhani (1998),Caporale (1996), Faria andLeón-Ledesma (2005),Belke (2000),
Oliveira and Santos(2007),Psaradakis andSola (1996), Santos(2004), andLiuandMorley (2014)investigatedthesameissuebutwithapplicationstotrade,consumption,businesscycle andfinancialmodelsusingdatachronologicallybacktoolderdecades.Followingthefindingsin superexogeneitymethodologyfromearlierstudies,thispaperisorganizedasfollows:Section2
brieflydescribestheproceduresfortestinginvarianceandsuperexogeneityhypotheses.Section
3 outlinesandestimatesamodelof thedemandfor moneyintheU.S.The followingSection
4 provides discussionsof the estimated resultswithpolicy implicationsandfinally Section5
concludes.
2. Superexogeneitytesting
Therehavebeen numerousattemptstotestthe constancyofparametersoverthe historical period.OneoftheinitialspecificationtestsisbyChow(1960),whichsimplyquestionsfor inter-actionswithdummyvariables(Engle&Hendry,1993).Incontrast,superexogeneityisspecifically designedtoascertainwhetherparametersare likelytoremainconstantinresponse tochanges inpolicyregime overthehistoricalperiod.Asanimportant measureof parameterstability,it is closelyrelatedtothetestof invariance,butthecauses,periods andmagnitudesof changes are identified bythe economiccircumstances, andthe historicalevidenceforregime changes areembodiedintheconditioningvariables.Thesuperexogeneitytestisperfectlyapplicableto the models of money demand, andthe Phillips curve,inparticular. Indeed, the instability of thePhillipscurve,especiallyattimesofexternalshocksandregimechanges,wasprobablythe mostfamousapplicationoftheinfluential“LucasCritique”(Bajo-Rubio,Díaz-Roldán,&Esteve, 2007).Duetothelackofopportunitiesofmajormonetarypolicyshiftsuntiltheglobalcrisis,the superexogeneitytestswereused inapplicationswithexchange rate,consumption,andsavings models thatentailrelativelyminorpolicyshifts intheliterature.ThestudiesincludeEricsson (1992),FaveroandHendry(1992),Caporale(1996),Karunaratne(1996),Valadkhani(1998),and
Habibullah,Azali,andBaharumshah(2001)whoexaminetherelevanceoftheLucasCritique. Manyeconometricstudiesrequirethedistinctionbetweenexogenousandendogenous vari-ablestobuildthemodelforstatisticalinference.Inthisregards,exogeneityisthekeytomany econometricanalyses,buttherearedifficultiesconcerningtheverydefinitionoftheterm(Engle, Hendry,&Richard,1983).Thisinconvenience asksfor furtherinvestigationof estimationon model parameters.Fortunately, Engleetal.(1983)contributetotheliteraturearguing thatthe superexogeneityiscloselyrelatedtotheLucasCritiqueand,asmentionedinCaporale(1996), servesasanimportantinstrumentforpolicyanalysis.
Weprovidethebriefexplanationofthesuperexogeneitytestingprocedureemployedtoassess therelevanceoftheLCbelow.Amoredetailedandcompleteprocedureofthetestingstrategy forsuperexogeneityisprovidedbyEngleetal.(1983).Westartbydefiningthejoint,conditional andmarginaldistributionsfollowingEngleetal.(1983)as:
Fk(kt;θt)=Fy|x(yt|xt;λ1t).Fx(xt;λ2t)
Aspertwoofthethreeversionsofexogeneitymentioned;avariablext issaidtobeweakly exogenousforasetofparametersofinterest(somefunctionsofθ)inaconditionalmodelofa variableYywithparametersλ1withkt=(yt,xt)if:
i) isafunctionoftheparametersλ1talone;
ii) λ1tandtheparametersofthemarginalmodelforxt,andλ2tarevariationfree,whichimplies
thatthereisnolossofinformationaboutfromneglectingthemarginalmodel(Caporale, 1996).
xtisdefinedassuperexogenousforif: i) xtisweaklyexogenousfor,
ii) changesinλ2tdonotcausechangesinλ1t.Here,aparameterisconsideredinvariantfora
classofinterventionsifitremainsconstantundertheseinterventions.Amodelisinvariantfor suchinterventionsifallitsparametersare(Engleetal.,1983)
Illustratively,Engleetal.(1983)modelthelinearregressionequation,whichishypothesized torepresenttheconstantconditionalmeanofarandomvariableytgivenanotherrandomvariable
xtaswellasotherinformation.Thesetechnicaldefinitionsarekeytosuggestingprinciplesfor designingpoliciessincedistinctionbetweenexogenousandendogenousvariablesenablesusto figureoutvariablesinvarianttopolicychanges.Considerthejointdistributionofthesevariables conditionalnormalwiththefollowingconditionalmeans:
E[yt|It]=μyt
E[xt|It]=μxt (1)
andcovariancematrix t= σyy σyx σxy σxx (2) wherextandytareconditionalontheinformationsetItthatcontainstheirpastvalues,andcurrent andpastvaluesofothervalidconditioningvariableszt.Theconditionalexpectationofytonxt
canbeexpressedas:
E(yt|xt)=λt(xt−μxt)+μyt (3)
and
yt−E(yt|xt)=ωt (4)
whereλt is theregression coefficientof yt onxt equalstoσyx/σxx,andωt isthe conditional varianceequalstoσyy−(σyx)2/σtxx.
Theconditionalmeanofytandxtisconsideredinthefollowingbehavioralrelationshipas:
μyt =βμxt +ztγ (5)
CombiningEqs.(3)–(5)yields:
Tosustainthisregressionanalysiswithweaklyexogenous,constantandinvariantparameters weneedthefollowingthreeconditions:
- Weakexogeneityofxtfortheparametersofinterest.Thisrequiresthatμxt,σtxx,andσtyxdonot entertheconditionalmodel,whichissatisfiedifλt =β.
- Constancyoftheparametersthatrequiresλt =λ.Sinceλt=σyx/σxx,theregressionmodelis homoscedasticifσyy=ω+λσtxx.
- Invarianceofβtothechangesintheprocessesgeneratingzt.
Withtheseconditionssatisfied,astandardregressionmodeltobeestimatedis:
yt=βxt+ztγ+ωt (7)
TowardtestingfortheempiricalvalidityoftheLC,EngleandHendry(1993)showthatthe effectsofpolicyshiftscanbeformulatedastheimpactofchangesinthemomentsofxt onthe parametersofβinthefollowinglinearexpansionform:
β=β0+β1μxt +β2σtxx+β3(σtxx/μxt) (8)
Bysubstituting(8)into(7)weobtain:
μyt =[β0+β1μxt +β2σtxx+β3(σtxx/μxt)]μxt +ztγ (9)
orinthefollowingformasaregression:
yt=β0xt+ztγ+(λt−β0)(xt−μxt)+β1(μxt)2+β2μxtσtxx+β3σtxx+ε1t (10)
Forsuperexogeneity,themomentsofxtshouldbeinsignificantandλtmustbeconstantover time.However,when t isnotconstant,EngleandHendry(1993)suggestalinearexpansion, suchas:
λt =σyx/σxx=λ0+λ1σxx (11)
BycombiningEqs.(6),(8)and(11)weobtainageneralalternativeregressionforthecaseof non-constant t:
yt=β0xt+ztγ+(λ0−β0)(xt−μxt)+λ1(xt−μxt)σxx+β1(μxt)2
+β2μxtσtxx+β3σtxx+ε2t (12)
Eqs.(10)and(12)canbeimplementedtotestforsuperexogeneitybyexaminingbotha condi-tionalmodelandmarginalmodelsfortheconditioningvariables.Here,wecaninterpretconditional andmarginalmodelsasagents’andpolicymakers’decisionrules,respectively(Giersbergen& Kiviet, 1996). Since policy makers oftenset targetsfor the endogenous variablesthat deter-minethebehavioroftheeconomicagents,policyrulesareaffectedfrompasteconomicoutcomes (Banerjee,Hendry,&Mizon,1996).Economically,superexogeneityoccurswhentheagentsform theirexpectationswithoutusingmodels,forinstancethehighcostofinformationoralowlevel ofbenefitsfrommodel-basedexpectations(Ericsson,Hendry,&Mizon,1998).
3. Modelsandtestresults
Westartbyreportingtheestimatesofthepolicyreactionfunctionusing(10)and(12).The conditionalandmarginalmodelsareconstructedwiththedemandformoneyintheUStocheck iftheLCisrelevantafter thepost-crisismonetarypolicyshift.Data arequarterlyandcapture theperiodbetween1990and2015.Theconditionalmodeldefinestherealmoneydemandasa dependentvariable(MD).Weassumethatmoneydemandisidentifiedbyacointegratingvector ofbothscalevariablesandthevariablesrepresentingtheopportunitycostofholdingmoney.Judd andScadding(1982)andHurnandMuscatelli(1992)modelsimilarrelationsfortheirstudies withdifferentspecificationsandanalysis.
Thescalevariablesinthemoneydemandfunctionrepresentwealtheffectsandtransactions. Realwealth,whichcapturestheassetmotivesofholdingmoney,isrepresentedbytheproxyof real financialassets ofnon-financialcorporate sectoras ashareofGDP(W/GDP). Theother scalevariableisrealGDP(GDP),representingeconomicactivityandhence,transactionsbased ondemandformoney.
Thesecondsetofvariablesdenotestheopportunitycostofholdingmoney,whichconsistsof bothitsownrateandalternativereturnsonmoney.Wedidnotincludeownrateofmoney,sincethe currentdeposits’rateshavelongbeenverylowintheUSanddonotcaptureobservablechanges. Asthemeasureofalternative returns,we addedthe interestrateonthe 3-monthUSTreasury Bill(TB),regardedasaclosemoney-substituteforegonebyholdingmoney.Allvariableswere convertedtorealvaluesusingtheGDPdeflatorandcomeinlogforms.Thecorrespondingmarginal modelswereconstructedforrealwealth,GDPandinterestratesasshowninTable1.
Therearetwoconditionsforsuperexogeneityasmentioned:forweakexogeneity,theresulting residualsfromthemarginalmodelmustbeinsignificantintheconditionalmodel.Asper superex-ogeneity(orstructuralinvarianceoftheparameters),theparametersoftheconditionalmodelmust beinsensitivetoinduced structuralchangesinthemarginalmodelparameters.Policyanalysis generallyinvolveschangingthemarginalprocessofxt.Foravalidanalysisundersuchchanges, theparametersλ1shouldbeinvarianttothosechanges/interventions.Ericsson(1992),Hurnand Muscatelli(1992),EngleandHendry(1993),Hendry(1995)andValadkhani(1998)statetheuse ofadummyvariabletotestsuperexogeneityempirically.Thisvariableisinsertedintoboth con-ditionalandmarginalmodelstorepresentstructuralchangeorpolicyshifts.Structuralinvariance issatisfied,ifitcomesoutsignificantinthemarginalmodelandsimultaneouslyinsignificantin theconditionalmodel.But,thenullofsuperexogeneitywillberejectedifthedummyaddedto thebasicconditionalmodelisproventobesignificantstatistically.Theregimeshiftorstructural changedummyvariableinthisstudyisdefinedasDUMt,whichcapturestheQEpolicyandtakes thevalueofzerountilthefourthquarterof2008,andonethereafter.
Inthefirststepofestimation,weconductedADFteststocheckforstationarityofthevariables anddetecttheirordersofintegration.Thetestresultsrevealedthatallvariablesareintegratedof orderone,I(1).
Wereporttheestimationresultsoftheparsimoniousdynamicconditionalmodelformoney demandbasedon(13)andderivedbythegeneral-to-specific(GTS)approach(Davidson,Hendry, Srba,&Yeo,1978;Engleetal.,1983).Theshort-rundynamicsinthemodelarecapturedbythe cointegratingvectorasanerrorcorrectionmechanism(ECMt–1),whichisstatisticallysignificant.
Theincludeddummyvariableisofparticularinteresttous,sinceitcapturesstructuralchanges. Asexpected,the signof itscoefficientestimateispositive, sincetheQEpolicywouldinduce higherdemandformoney.Itscoefficientisalsosignificantintheconditionalmodel,validating
Table1
Marginalmodelsforxt. Marginalmodelforwealth ΔWt=−0.034ECMt−1 [0.009] + 0.417ΔWt−2 [0.077] + 0.089ΔSMIt [0.015] +0.002DUM[0.001] t Sampleperiod:1990Q1–2015Q4 R2=0.417 ¯R2=0.400 σ=0.005 DW=1.62 SerialcorrelationF(2,98)=2.805 HeteroscedasticityARCHF(2,99)=0.551 ChowbreakpointtestF(3,98)=2.901
MarginalmodelforGDPa ΔGDPt=−0.03ECMt−1 [0.019] +0.463ΔGDPt−1 [0.083] +0.161ΔLt−1 [0.074] +0.118ΔCAPt [0.038] +0.001DUM[0.0005] t Sampleperiod:1990Q1–2015Q4 R2=0.286 ¯R2=0.258 σ=0.002 DW=2.263 SerialcorrelationF(2,97)=3.44 HeteroscedasticityARCHF(2,99)=3.106 ChowbreakpointtestF(4,96)=7.736
Marginalmodelfortreasurysecurity ΔTBt=−0.063ECMt−1 [0.019] +0.629ΔTBt−1 [0.072] −0.135 [0.09] +31.62ΔINF[31.895] t+0.135DUM[0.078] t Sampleperiod:1990Q1–2015Q4 R2=0.474 ¯R2=0.454 σ=0.307 DW=2.134 SerialcorrelationF(2,96)=2.37 HeteroscedasticityARCHF(1,100)=1.996 ChowbreakpointtestF(4,96)=3.092
aHACestimationresults.
doubtsontheconditionofthestructuralinvariance.Thismeansthatshiftsinthemonetaryregime havesignificantconsiderableeffectonmoneydemand,highlightingtheimportanceofbehavioral factorssuchasexpectations,asstatedbytheLC.
Theserialcorrelationandheteroscedasticitytestresultsaresatisfactory.Furthermore,wereport theresultsofcumulativesum(CUSUM)test(Fig.1)documentingthattheregressionisstable overthesampleperiod.
ConditionalmodelforUSmoneydemand
ΔMDt =−0.003ECMt−1 [0.002] + 0.507ΔMDt−1 [0.076] +0.24ΔMDt−3 [0.074] +0.044Δ(W/GDP)t−4 [0.022] −0.24ΔGDPt−1 [0.101] =+0.358ΔGDPt−3 [0.088] + 0.001ΔTBt−2 [0.0005] − 0.002ΔTBt [0.0005] −0.045ΔGDPt [0.093] + 0.001DUMt [0.0005] (13) Sampleperiod:1990Q1–2015Q4 R2=0.594 ¯R2=0.555 σ=0.0023 DW=2.67 SerialcorrelationF(4,90)=1.548 HeteroscedasticityARCHF(4,95)=0.9934
Fig.1.CUSUMoftheconditionalmodel.
Thenextstepintheprocedureistoestimatethemarginalmodelsforxt,reportedinTable1. Webuiltandestimatedseparatemarginalmodelsofthementionedscalevariables–wealth,GDP andTreasuryBillrates.Inbuildingthemodels,wereliedonbasicmacroeconomicdeterminants (Hurn&Muscatelli,1992).Asamaindeterminantofwealth,weputS&PStockMarketIndex (SMIt) and its own lag. Second marginal model explains the GDP as functions of labor (L,
measuredbylaborparticipationratio)andrealcapital(CAP)basedonCobb-Douglasproduction function(allvariablesareinlogforms).Lastly, thethirdmarginalmodeltestifiesinterestrate (Treasury Bill rates) by inflation (INF, measured by the GDP deflator)and its lagged value fromtheprevious period.Marginalmodelsqualify tobestableandrevealmainlysatisfactory diagnosticresults.ThemarginalmodelofGDPwasestimatedusingHACerrorstoaccountfor heteroscedasticity detectedwhile testing.Thesignsof all significantcoefficient estimatesare consistentwithestablishedunderlyingtheory,andtheECMdisplayssignificantcoefficientsin all models.Most importantly,included dummies, whichcapture amajor QEshift, also have significantcoefficientsinallmodels.ThisindicatesthatimplementationoftheQEplaysacrucial roleinmodelingmaineconomicrelationshipsinpolicymodeling,byvalidatingchangesinthe actualstructuralparametersoftheeconometricmodels.Ourempiricalfindingsascertainthatthe parametersintheeconometricmodelofthemoneydemandrelationship,whichislargelyused bypolicymakers,havechangedinresponsetochangesinQEregimeafter2008.Therefore,the consequentactionsoftheeconomicagents,suchastheirdecisionsconcerningassetaccumulation, economicactivityandpurchaseofbondswouldlargelydependontheirexpectations,basedmainly ontheQEpolicyitself.
Table2 displays importanttestresults toprovide furthersupporttothe validityof the LC associatedwithpolicy-basedexpectations.Entiresetofresidualsfromthemarginalmodelsare statisticallyinsignificantintheconditionalmodeltodocumentthattheconditionofweak exogene-ityissatisfied.Ontheotherhand,thesameisnottruefortheconditionofstructuralinvariance, sincethedummyissimultaneouslysignificantinboththemarginalmodel(s)andtheconditional model. Basedonthesefindings we concludethat the nullof superexogeneityis rejected.We commentthatthemodelweconstructedformoneydemandispronetotheLC.
Table2
Superexogeneitytestresults.
Test Nullhypothesis t-statistic
Weakexogeneity εW t =0 1.558 εTS t =0 0.061 εGDP t =0 −1.635 Invariance
MarginalmodelofW DUM=0 1.948*
MarginalmodelofTB DUM=0 1.718*
MarginalmodelofGDP DUM=0 3.356***
Conditionalmodel DUM=0 1.802*
***,**and*indicatesrejectionofthenullhypothesisatthe1%,5%and10%significancelevel,respectively.
4. Discussionandcommentsonpolicyimplications
Analyzing agents’expectationsandtheirbehaviorbasedonthe expectationsisessential in settingacredibleandefficientcentralbankpolicytomanipulateeconomicactivities.Assuch, our paperaddresses anactivepolicy debatewhile alsoaddressinggrowing concern aboutthe managementofexpectationsbymonetaryauthorities.Wemakeuseoftheunconventional mon-etarypolicytoolofQEtoprobetheimpactofQEonagents’behavior.Inthisregard,anchoring announcedtothepublic appearas acrucialmeansof shapingthe expectations.Yellen(2013)
statesthatwell-anchoredinflationexpectationshaveproventobeanimmenseassetinconducting monetary policyafterthe2008crisis.Recentstudiesstipulatethatcommitmentof theFEDto itspre-announcedinflationrateandtheresultingformationofexpectationshelpedavoidthe pro-longeddisinflationaryprocessassociatedwiththepost-crisishighratesofunemployment(Ball& Mazumder,2015).Whileadaptive/past-basedexpectationsmaybeareasonablepremiseinsome circumstances,predictivemonetarypolicy,transparentcommunication,andstableexpectations playacrucialrole,sincetheyinfluenceallsortsofbehaviorandmayhelpavoidmajorinstabilities predictedbystandardmodeling.Similarly,Trichet(2010)explainstheuseofanchoringas“First, theprecisequantitativenatureofourdefinitionofthepricestabilityobjectivehasprovedcrucial inanchoringlonger-terminflationexpectations.And,asaresult,ithasprotectedusagainstboth upsideanddownsideriskstopricestability,eveninthesemostturbulentoftimes.Theanchoring of privateinflationexpectationsinducesaself-correctingmechanisminresponse totemporary disturbancesinpricedevelopments,therebyeasingtheburdenonmonetarypolicy.”
Regardingtheperformanceofeconomicagentsinformingtheexpectations,theglobalfinancial crisis setthe stage for realization of such expectations’ successor failure,especially for the nearfuture.Weexemplifytheexpectationsbytwoprofessionalsandaninstitutionwithprimary businessofdealingwithrisktoassessthecapabilityofeventhemostexperiencedprofessionals. In 2005, the FED former chairman, Alan Greenspan stated “Overall, while local economies mayexperiencesignificantspeculativepriceimbalances,anationalseverepricedistortion(i.e. ahousingbubble) seemsmostunlikelyinthe UnitedStates, givenitssizeanddiversity.”The secondprofessionalisalsoaFEDchairman,andaprofessorofmacroeconomicswithtextbooks andinfluential paperspublished; BenS. Bernanke stipulated“The riskthat the economyhas enteredasubstantialdownturnappearstohavediminishedoverthelastmonthorso”inJune2008, onlyaboutthreemonthsbeforeLehmanBrothersdeclaredbankruptcyonSeptember15,2008. ThefailureintheforecastoftwoofthemostexperiencedprofessionalsintheUSvalidatedthe
importanceoftheunpredictablebehaviorofexpectations,whichnecessitatedfurtherinvestigation. WhatGreenspancouldnotanticipatewasthelowestpricegrowthcorrelationjumpingfrom−0.6 to0.17,ahistoricalunprecedentedchange.Bernanke’sfailureisreasonedbyamuchlargersetof datathatwassomehowmisinterpreted.Inaddition,theAmericanInternationalGroup(AIG),the giantconglomeratespecializingininsuranceandrisktaking,wasnotabletoforeseetheupcoming suddenfallofhomepricesbeforebeingfiledforbankruptcy.
Theongoingpaceofeconomicvariablesintheirpleasingexpectedrangesshouldnotmake pol-icydesignerslosetheiralertness.AsMishkin(2011b)indicated“UpuntilAugust2007,advances inboththeoryandempiricalworkinthestudyofmonetaryeconomicshadledbothacademic economistsandpolicymakerstoarguethattherewasnowawell-defined“scienceofmonetary policy”.Therewasageneralconsensusincentralbanksaboutmostelementsofmonetary pol-icystrategy,andmonetarypolicywasperceivedasbeinghighlysuccessfulinOECDcountries, withnot onlylowinflation,but alsolow variabilityof inflation.In addition, outputvolatility haddeclinedin thesecountries,andthe periodsince the early1980swas dubbedthe “Great Moderation”.Monetaryeconomistsandcentralbankers“werefeeling prettygoodabout them-selves.”Thesewerethedescriptionsofhowmonetary authoritiesfeltrightbeforetheturmoil. Emergenceofthemacroprudentialpolicyhastobeemphasizedtowardeffortsofdetectingand preventingcrisesevenbeforetheybecomeeffective.Mishkin(2011a) recommendsthe useof macroprudentialpolicyas“Macro-prudentialregulationscanbeusedtodampentheinteraction betweenassetpricebubblesandcreditprovision.Othermacro-prudentialpolicies toconstrain creditbubblesincludedynamicprovisioningbybanks;lowerceilingsonloan-to-valueratiosor higherhaircutrequirementsforrepolendingduringcreditexpansions;andPigouvian-typetaxes oncertainliabilitiesoffinancialinstitutions.”
5. Conclusion
Economistsagreeonthefactthattheshockstothefinancialsystemresultingfromtheglobal financialcrisiswereinmanywaysmorecomplicatedcomparedtothosetriggeredbytheGreat Depressionofthe1930s,andyet,theconsequentcontractionofeconomicactivityappearedtobe lesssevere(Mishkin,2011b).AlthoughTaylor(2014)believesthatpost-crisisaggressivemonetary policywasnotaseffectiveasexpected,Mishkin(2011b)suggestsitwasthebesttoolthatcould beimplementedtomitigatetheshocks,sincetheseverityofthecrisisin2008overwhelmedthe abilityofconventionalmonetarypolicytocounteractit.Exceptforefficiencydebates,theregime changesrekindledquestionsontheLucasCritiquethatnaturallyariseintheenvironmentofmajor policyshift.
Followingthe emergence of the LC, monetary modelsposed challenges inregardto their potencytoexplain/forecastinflationdynamicsandasapolicytool,duetotheirinabilityto accu-ratelycapturethebehavioroftheagentsafterashift.AccordingtothemainargumentofLucas, anychangeinthemacroeconomicpolicy,suchasQEinourcase,willaltertheexpectationsof theagents whomake assessmentsbyconsideringthefutureratherthanthepast andtheywill adapttheirexpectationsandbehaviortothenewpolicystance.Lucasstressedontheparameters oftheeconometricmodelthatbecomeunstableacrossdifferentpolicyregimes.Monetaryshifts suchasthe QEpolicycarryhighpossibilitytoalterthestructureofpast-data-basedeconomic models,asforeshadowedintheLC.IftheLCholds,itisdeceptivetofocussolelyonthepastwhen economicconsequencesofsuchpoliciesaredetermined,wherebyexpectationsplayasignificant roleinshapingthem.Indeed,themanagementofexpectationsaboutfuturepolicyhasbecomea centralelementofmonetarytheorywithzero-boundpolicies,ashighlightedinMishkin(2011b).
At the same time, the QE period represents an interesting andunique case of study. Our empirical estimatesrejectthecondition ofsuperexogeneityorparameterinvariance,providing credibilitytotheLC.ThisiscontrarytoHurnandMuscatelli(1992)whichseemstobetheonly empiricalpaperthattestsLCvalidityviasuperexogeneitymethodology(intheexampleoftheUK moneydemandovertheperiod1966Q4–1989Q4).Severalotherworks(Bajo-Rubioetal.,2007; Estrella&Fuhrer,2003;Leeper&Zha,2003)generallyfoundnoormodestquantitativeimpact ofLCinmonetaryrelationships,whileRudebusch(2005)arguesthatthemainreasonwhymost ofthestudiesfailtodetecttheLCisthatshiftsinthepolicyrulemaybeunimportanthistorically. Indeed,theQEperiodrepresentstheopportunityofradicalpolicyshiftscapturingmassiveliquidity provisions,purchasesofbothgovernmentandprivateassets,anddramaticexpansionoftheFED’s balancesheet.Thismightbeoneexplanationforourresultsthatsignificantlysupportthevalidity oftheLCinthemodelofmoneydemandintheUS.
Inthecontextofourfindings,whatpolicymakersshouldconsiderishowtodealwiththose parameterinconstanciesandtherefore,withexpectations.Theinstabilityofmonetarymodelsin thepresenceofstructural breaks(followingregimeshifts)wouldmeanconsiderablechallenge fortheiruseasapolicytool.However,Bernanke(2009)suggeststhatexpectations,ifeffectively monitored,canratherbeusedasanadditionaltooltomanagetheimplicationsofpolicychanges, especiallyintheenvironmentofzero-boundpolicy.AstheformerFEDchairmanYellen(2013)
stressed,managementofexpectationshasproventobeanimmenseassetinconductingpost-crisis policiesandminimizingpolicies’potentialcoststotheeconomy.
Thetheoreticalliteraturestronglysupportsexpectationmanagementtostimulateconsumption duringthezero-boundperiodbecauseacommitmenttomaintainlowshort-terminterestratesfora longertimetriggerslowerlong-terminterestratesandsimultaneouslyraisesinflationexpectations, therebyreducingtherealinterestrates,andhelpingtocontinuezero-boundpoliciesforalong periodoftime(Eggertsson&Woodford,2003).Withstrongcommitment,clearcommunication andbroadguarantees,policymakerscanactuallygettheagentstoreactmorefornewpolicies. Manyoftheactualprogramsimplementedduringthecrisishadelementsofguarantees,although theycouldusethemmoreextensively(Caballero,2010).TheIMF(2013)stipulatesthatproviding maximum clarityto the public aboutthe expansionary policies (therebyanchoringlong-term inflation expectations) helped the FED avoidprolonged deflation that started after the crisis, and atthe sametime, increaseits flexibilitytouse securities purchasesto provideadditional accommodation.Forinstance,therateofUScoreinflation2in2011wasclosetoitslevelbefore 2008,despitetheshort-runpredictionofthePhillipscurvethathighunemploymentrateswould draginflationrateswellbelowzero(Ball&Mazumder,2015).Thepapersuggeststhatoneofthe reasonsforthisisthattheFed’scommitmenttoa2%inflationtargethaskeptexpectedinflation near2%,whichinturnhaspreventedactualinflationfromfallingveryfarbelowthatlevel.
TheuseofamonetarypolicybasedonQE1-2-3,overall,wasanaccomplishmentandhelpful tomitigatedestructiveshocksbythefinancialsystem.TheFEDwaslargelysuccessfulin admin-isteringandevenmanipulatingtheexpectations–assuggestedbyLucas–andmadeuseofdrastic changeinthemonetarypolicyregimetokeepthegrowthrate,aswellastheunemploymentrate, atdesirablelevelsdespitethedisastrousmagnitudeof theglobal financialcrisis.Thetrendsin theUSgrowth,unemploymentandinflationratesprovidedinTable3andFig.2,infact,support relativesuccessofthosecombinedpolicies.
Table3
US real GDP growth, unemployment and inflation (Source: Federal Reserve Economic Data, FRED,
https://fred.stlouisfed.org).
Year GDPgrowth(annual%) Unemployment(%oftotallaborforce) Inflation,GDPdeflator(annual%)
2000 4.13 3.97 2.20 2001 1.00 4.74 2.20 2002 1.74 5.78 1.60 2003 2.86 5.99 1.90 2004 3.80 5.54 2.70 2005 3.51 5.08 3.10 2006 2.85 4.61 3.00 2007 1.88 4.62 2.70 2008 −0.14 5.80 1.90 2009 −2.54 9.28 0.80 2010 2.56 9.61 1.20 2011 1.55 8.93 2.10 2012 2.25 8.08 1.90 2013 1.84 7.36 1.80 2014 2.45 6.16 1.90 2015 2.88 5.28 1.10 2016 1.57 4.88 1.10 2017 2.22 4.35 1.90 2018 2.86 3.89 2.30
Fig.2.TrendsofUSrealGDPgrowth,unemploymentandinflation(2000–2018).
Currently,centralbanksusemodelsfreefromtheLC.AsindicatedbyIsrael(2016),theFed employstwoDSGEmodels,whicharerevisedandextendedversionsofthemodelspresentedin
Christiano,Eichenbaum,andEvans(2005)andSmetsandWouters(2007),respectively.Similarly, twoofthemostimportantmodelsusedbytheECBaretheNewAreaWhiteModel,basedon
SmetsandWouters(2003),andtheCMRModelbasedonChristiano,Motto,andRostagno(2010). Another example of preparing andmanaging expectations can beobserved inthe gradual increaseofinterestrateswiththefirstactualtighteninginDecember2015.Theincreaseinthe rateswassufficientlysmallandgradual,accompaniedbyprioreffectivecommunicationswiththe public,havingprovidedclearsignalsaboutfuturetightening.Asaconsequence,bothdomestic andinternationalimpactsweresmooth,whilerelativedepreciationofothercurrenciesagainstthe dollarhadstartedwellbeforetheactualFED’stightening.Thisislargelyduetotheexpectations
formedbythespeechesoftheFEDchairpersonsfrom2013abouttheirintentionstogradually tempertheQEregime.
AsBernanke(2009)mentioned,theFEDpromptedconsiderableeffortin“developingasuiteof toolstoensurethattheexitfromhighlyaccommodativepoliciescanbesmoothlyaccomplished when appropriate, andFOMC participantshavespoken publiclyabout thesetools on numer-ous occasions”. Given the existence of structural breaks and associated expectation changes documented byourresults, acentralbankcommitmentthat firmlyanchors long-runinflation expectations canmake an important contributiontothe effectiveness of its policies aimedat stabilizingandstimulatingeconomicactivityinthefaceofadversedemandshocks.The recom-mendedactswouldincludecontinuingtoactivelyreviewitscommunicationstrategy,andtomake itsoutlookandpolicyintentionsasclearaspossible.Thecommitmenttocertainnominalanchors isnotnecessarilylimitedtoinflationexpectations,butalsoextendstootherindicatorssuchas moneysupplyandexchangerate.Ourevidenceofthesuperexogeneityinthisworkcompatibly highlightsthecrucialroleofthemanagementofexpectations,seeminglyshaped bythepolicy itself.Transparency,communicationandcrediblecommitmentofthecentralbankshavebecome importantelementsforsuccessfulmonetarypolicyoutcomes,whicharetrulypossibleunderthe conditionofcentralbankindependence.
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