Aggregate disturbances, monetary policy, and the macroeconomy: the FRB/US perspective

The FRB/US macroeconometric model of the U.S. economy was created at the Federal Reserve Board for use in policy analysis and forecasting. This article begins with an examination of the model's characterization of the monetary transmission mechanism -- the chain of relationships describing how monetary policy actions influence financial markets and, in turn, output and inflation. The quantitative nature of this mechanism is illustrated by estimates of the effect of movements in interest rates and other factors on spending in different sectors and by simulations of the effect of a change in the stance of policy on the economy as a whole. After the discussion of the transmission mechanism, the article considers the influence of monetary policy on the macroeconomic consequences of specific events by showing how the predicted effects of selected disturbances change under alternative policy responses. These examples illustrate an important policy tradeoff in the FRB/US model involving the variability (but not the level) of output and inflation: Past some point, lower variability in inflation can be obtained only at the expense of greater fluctuations in output and interest rates.Forecasting ; Macroeconomics ; Monetary policy

Summary of papers presented at the conference "models and monetary policy: research in the tradition of Dale Henderson, Richard Porter, and Peter Tinsley"

On March 26 and 27, 2004, the Federal Reserve Board held a conference in Washington, D.C., on the application of economic models to the analysis of monetary policy issues. The papers presented at the conference addressed several topics that, because they are of interest to central bankers, have been a prominent feature of Federal Reserve research over the years. In particular, the papers represent research in the tradition of work carried out over the past thirty-five years at the Federal Reserve by three prominent staff economists -- Dale W. Henderson, Richard D. Porter, and Peter A. Tinsley. Thus, the conference partly served as a celebration of the contributions made by these individuals to policy-related research since the late 1960s. ; Among the specific topics addressed at the conference were the influence of uncertainty on policymaking; the design of formal rules to guide policy actions; the role of money in the transmission of monetary policy; the determination of asset prices; and econometric techniques for estimating dynamic models of the economy.Monetary policy ; Econometric models

The role of expectations in the FRB/US macroeconomic model

In the past year, the staff of the Board of Governors of the Federal Reserve System began using a new macroeconomic model of the U.S. economy referred to as the FRB/US model. This system of mathematical equations, describing interactions among economic measures such as inflation, interest rates, and gross domestic product, is one of the tools used in economic forecasting and the analysis of macroeconomic policy issues at the Board. The FRB/US model replaces the MPS model, which, with periodic revisions, had been used at the Federal Reserve Board since the early 1970s. A key feature of the new model is that expectations of future economic conditions are explicit in many of its equations. Because of this clear delineation of expectations, the FRB/US model can be used to study issues that would be difficult or impossible to study with the MPS model. For example, the new model can show how the economy's response to specific events, such as a reduction in defense spending, may vary considerably with the speed at which the public recognizes that the event has occurred or will occur.Econometric models ; Federal Reserve System ; Forecasting

Have we underestimated the likelihood and severity of zero lower bound events?

Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve's asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1-1/2 percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.Inflation (Finance) ; Interest rates ; Macroeconomics - Econometric models

What Fiscal Policy is Effective at Zero Interest Rates?

Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today

Gauging the uncertainty of the economic outlook from historical forecasting errors

Participants in meetings of the Federal Open Market Committee (FOMC) regularly produce individual projections of real activity and inflation that are published in summary form. These summaries indicate participants' views about the most likely course for the macroeconomy but, by themselves, are not enough to gauge the full range of possible outcomes -- that is, the uncertainty surrounding the outlook. To this end, FOMC participants will now provide qualitative assessments of how they view the degree of current uncertainty relative to that which prevailed on average in the past. This paper discusses a method for gauging the average magnitude of historical uncertainty using information on the predictive accuracy of a number of private and government forecasters. The results suggest that, if past performance is a reasonable guide to the accuracy of future forecasts, considerable uncertainty surrounds all macroeconomic projections, including those of FOMC participants.Uncertainty ; Economic forecasting

Systematic Departures from the Frontier: A Framework for the Analysis of Firm Inefficiency.

Departures from a production or cost frontier may reflect the systematic effect of conditions that contribute to inefficiency. To test whether some portion of frontier function departures can be systematically explained, the frontier inefficiency error component is modeled as a function of various causal factors and a random component. The functional form of the inefficiency error term model is chosen to assure strict one-sidedness. Preliminary empirical results generated from electric utility data suggest the superiority of including both systematic and random components in the efficiency error term. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.