Greenspan, Alan ; Monetary policy ; Business cycles

N. Gregory Mankiw

English

Research Papers in Economics

In most academic studies of optimal monetary policy, a central
bank is assumed to have two main objectives. One objective is
keeping inflation low and stable. The other is keeping the economy’s
output of goods and services close to its potential—or, equivalently,
keeping unemployment close to its natural rate. This approach has
two virtues. The first is that it is consistent with basic theory: Under
some reasonable conditions, this objective function can be derived as
a reduced-form expression for the utility of the representative house-
hold. Just as important, this objective function appears to
approximate those things that real central bankers (as opposed to the
hypothetical central bankers in a theorist’s model) really care about.
Optimal policy in these models often takes the form of a Taylor
rule. The central bank is supposed to set the short-term interest rate
as a function of inflation and the deviation of output from potential. 
Bob Hall’s paper takes aim at the practical application of this frame-
work. He argues for three related but distinct propositions. First, he
claims that it is difficult to estimate potential output, especially
contemporaneously. Second, he argues that potential output exhibits
substantial high-frequency variation, so the normal presumption that
it follows a smooth trend is suspect. Third, he suggests that modern
N. Gregory Mankiw
Commentary: Separating the Business
Cycle from Other Economic Fluctuations
187theories of the labor market call into question the very concept of the
natural rate of unemployment and thus potential output. 
The bottom line from these arguments is that central bankers
should be wary when their staff of economists produces estimates of
potential output and the output gap and that they should avoid
relying on these estimates when setting monetary policy. The alterna-
tive is to focus almost exclusively on the other variable in their
objective function—the rate of inflation.
I agree with Bob’s first argument completely. The natural rate of
unemployment and potential output are extraordinarily difficult to
estimate. Work by Staiger, Stock, and Watson (published in a
National Bureau of Economic Research, NBER, conference volume
about a decade ago) convinced me that estimates of the natural rate
come with a huge standard error. The fundamental problem is that
the residuals in the Phillips curve are so large that the parameters of
this relation cannot be estimated with much precision. Even if the
natural rate were completely constant, it would take many years of
data to pin it down precisely. And the fact that the natural rate
changes over time as a function of demographics, institutions, and
labor-market policies only makes the problem worse.
This means that central bankers should be suspicious of any esti-
mate of the natural rate. Excessive reliance on imprecise measures can
be a significant problem. It was probably not a coincidence that the
1970s were a decade characterized by both rising inflation and a
rising natural rate of unemployment. Not realizing how much the
natural rate had risen, the Fed thought that there was more slack in
the economy than there really was. Despite several decades of research
since then, I am not sure that today’s economists, faced with a similar
set of events, would be any better at estimating a change in the
natural rate in real time.
Bob’s second claim is that potential output exhibits significant
high-frequency variation. I find this conclusion less compelling. He
reaches this result by feeding measures of total factor productivity
188 N. Gregory Mankiw
 into a neoclassical growth model, using the model’s predicted output
as a measure of potential. This measure of potential output moves
around a lot, suggesting that much of the variation in actual output
does not translate into movements in the output gap.
It is well-known that total factor productivity fluctuates substantially
over the business cycle. The question is how to interpret that fact. The
real business cycle theories on which Bob is building treat movements
in total factor productivity as if they were exogenous changes in the
economy’s productive technology. But these movements could just as
easily be endogenous responses to the business cycle. If businesses
hoard labor in downturns to avoid hiring and training costs when the
economy turns around, then labor effort could well be cyclical,
causing total factor productivity to be procyclical. But this need not
mean that technology and potential output are changing.
Let me be clear that I am not suggesting that I know that potential
output follows a smooth trend, as is so often assumed. Bob, along with
the real business cycle theorists, has raised the real possibility that
potential output does exhibit high-frequency variation. The unex-
pected acceleration in productivity growth since 1995—most likely
associated with information technology—does highlight that potential
output can move around. But I don’t think the kind of calculations
presented in this paper shed much light on how substantial the year-
to-year fluctuations in potential output really are.
The third line of argument that Bob pursues in this paper is the
suggestion that the whole distinction between the natural rate of
unemployment and cyclical unemployment is misguided. From my
perspective, this part of the paper is half-baked. This is not to say that
the argument is wrong, only that it is insufficiently developed to eval-
uate it with much confidence. 
The distinction between natural and cyclical unemployment has its
foundation in Milton Friedman’s classic address to the American
Economic Association, where Friedman forcefully propounded the
Commentary 189
 hypothesis that monetary policy has important effects on output and
unemployment in the short run, but no effects on such real variables
in the long run. This natural rate hypothesis is part of most modern
theories of the business cycle, and it is what generates the distinction
between natural unemployment as the steady state toward which the
economy gravitates in the long run and cyclical unemployment as the
short-run deviation of unemployment from that steady state.
Rejecting the distinction between natural and cyclical unemploy-
ment is, therefore, tantamount to rejecting Friedman’s natural rate
theory. It is not clear, however, what Bob would put in its place. The
real business cycle theorists want us to assume that monetary policy
is incapable of affecting output and unemployment even in the short
run. Bob is too practical of a macroeconomist to take that proposi-
tion seriously, but he has not fully spelled out what his alternative
vision is.
In the end, I agree with Bob that monetary policy makers should
take estimates of potential output and the natural rate of unemploy-
ment with more than a grain of salt. But I am disinclined to sign on
to his suggestion that we reject the textbook approach to economic
fluctuations. Instead, I agree with him for the more prosaic reason
that these variables are hard to estimate with much precision.
This brings me to the policy question: If we cannot estimate poten-
tial output or the natural rate of unemployment, what are monetary
policy makers to do? The obvious alternative is to focus exclusively on
inflation, as some inflation-targeting central banks are doing now. 
Such a regime of pure inflation targeting would seem to be inconsis-
tent with the Fed’s dual mandate of being concerned about both price
stability and full employment. It turns out, however, that this is not
necessarily the case. In some modern theories of the business cycle, a
monetary policy that aimed exclusively at stabilizing the price level
would achieve, as a byproduct, stabilization of output at its potential
level. Olivier Blanchard has called this fact the “divine coincidence.” If
190 N. Gregory Mankiw
 the divine coincidence is actually true, it would conveniently solve the
conundrum raised in this paper, for the central bank would not need
to measure potential output in order to keep actual output at potential.
It only would need to stabilize prices.
Let me spend a few minutes explaining why the divine coincidence
might be true. Consider first shocks to the aggregate demand for
goods and services. Expansionary demand shocks tend to push prices
up and output above potential; contractionary demand shocks put
downward pressure on prices and depress output below potential.
Because the price level and the output gap are moving in the same
direction, a monetary policy that stabilizes one will automatically
stabilize the other. In other words, a central bank that follows a policy
of pure inflation targeting will, as a desirable side effect, insulate
output from shocks to aggregate demand.
Now consider shocks to productivity. A positive shock to produc-
tivity, such as those we have experienced since 1995, puts downward
pressure on prices and tends to increase output. A central bank
committed to pure inflation targeting would respond with more
expansionary policy, increasing output further. This might seem to be
destabilizing output. But remember that the positive productivity
shock also raises potential output. In many standard models, these
two effects exactly balance. That is, if the central bank keeps the price
level on target, output and potential output will increase by exactly
the same amount in response to a positive productivity shock. Once
again, stabilizing prices automatically stabilizes output at potential.
You can now see why Blanchard calls this the divine coincidence.
Is this coincidence true in the world, or is it just an artifact of some
oversimplified macroeconomic theories? The literature on this topic
is not sufficiently developed to give a definitive answer, but my guess
is that it is more likely an artifact. One can certainly write down a
model well-grounded in theory in which the divine coincidence does
not arise. The key feature of such models is that supply shocks are not
simply shifts in productivity but also represent shifts in how distorted
Commentary 191
 192 N. Gregory Mankiw
the economy’s production process is. For example, imagine that because
of market power, prices are a markup over marginal cost. If supply
shocks in part represent shifts in the size of that markup, then it turns
out that the divine coincidence does not arise. In this case, monetary
policymakers face a tradeoff between stabilizing inflation and stabiliz-
ing the output gap. Whether this kind of supply shock is an important
feature of the world is, I believe, a crucial unanswered question.
So, what does all this mean for the practice of central banking?
Unlike Bob, I am not ready to give up on concepts such as potential
output and the natural rate of unemployment. But I agree with him
that we measure these concepts poorly and that this fact suggests
increased emphasis on measures of inflation. Some might argue for an
exclusive focus on inflation, but I don’t see the current state of mone-
tary theory as necessarily supporting such an extreme view. In the
end, central bankers have little choice but to look at all the data, apply
a healthy dose of skepticism, and muddle through.
 

Commentary : separating the business cycle from other economic fluctuations

http://www.kansascityfed.org/Publicat/sympos/2005/PDF/Mankiw2005.pdf

Commentary : separating the business cycle from other economic fluctuations

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