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Mankiw, N. Gregory

Article Monetary economics

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Suggested Citation: Mankiw, N. Gregory (2003) : Monetary economics, NBER Reporter Online, National Bureau of Economic Research (NBER), Cambridge, MA, Iss. Spring 2003, pp. 1-5

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NATIONAL BUREAU OF ECONOMIC RESEARCH

Reporter OnLine at: www.nber.org/reporter SPRING 2003

IN THIS ISSUE Program Report Program Report: Monetary Economics 1 Research Summaries: Monetary Economics Explaining Exchange Rate Behavior 5 N. Gregory Mankiw* Health, Income, and Inequality 9 Patents 12 NBER Profiles 15 Understanding what monetary policy can do to enhance economic Conferences 17 performance (and, just as importantly, what it cannot do) is a continuing Bureau News 22 challenge for economic policymakers around the world. Researchers in Bureau Books 48 the NBER’s Monetary Economics Program contribute to this effort with Current Working Papers 49 a combination of theoretical and empirical studies on the effects of cen- tral bank actions and the design of monetary policy. These studies are circulated as NBER Working Papers, presented and discussed at regular Program meetings, and subsequently published in NBER volumes and academic journals. Our regular program meetings also aim to facilitate interaction between researchers working in universities and those working in central banks. Much frontier research on monetary economics occurs within research staffs of the System and other central banks around the world. These central bank researchers often are invited to present their work and to participate in the discussion of other recent studies. We are delighted that Ben S. Bernanke, one of our long-term members and program director for the past two years, was appointed by President George W. Bush in 2002 to become a Governor of the Federal Reserve. When he was confirmed, I returned to the role of Program Director, which I had held previously. In this report, I summarize a few of the strands of research on mon- NBER Service Brings etary economics that have engaged NBER researchers in recent years. You New Data for Free None of these issues is fully settled, but significant progress has been made. In the process, I will offer a few of my own judgments about what A new, free NBER email serv- we know and about where more research is still needed. ice gives you daily email links to all U.S. government data releases, The Dynamic Effects of Monetary Policy including unemployment, trade, interest rates, GDP, etc. We keep According to textbook theory, changes in monetary policy influence track of your preferences and employment and production in the short run but, in the long run, affect email you the requested links when they are released. To sign up for any or all of the government * Mankiw is Director of the NBER’s Program on Monetary Economics and the releases, visit www.nber.org/releases Allie S. Freed Professor of Economics at (see page 24). The and register your choices. IT’S numbers in brackets throughout this report refer to NBER Working Papers. A com- FREE!! plete list of NBER Monetary Economic Working Papers can be found at http://papers.nber.org/papersbyprog/ME.html

NBER Reporter Spring 2003 1. only prices and inflation rates. When a central bank slows the rate of money growth, for instance, the end result will be a lower rate of NBER Reporter inflation, but the transition to lower inflation NATIONAL BUREAU OF ECONOMIC RESEARCH can take some time, and it often entails a peri- od of depressed economic activity, including higher unemployment. This short-run tradeoff The National Bureau of Economic Research is a private, nonprofit research between inflation and unemployment is often organization founded in 1920 and devoted to objective quantitative analysis of called the , after the classic study the American economy. Its officers and board of directors are: of this topic by A. W. Phillips in the 1950s. President and Chief Executive Officer — Martin Feldstein Much research in the NBER Monetary Vice President for Administration and Budget — Susan Colligan Economics Program has been devoted to doc- Controller — Kelly Horak umenting and explaining these dynamic BOARD OF DIRECTORS responses to monetary policy. One approach to this empirical issue is to Chairman — Michael H. Moskow Vice Chairman — Elizabeth E. Bailey study particular episodes of disinflationary Treasurer — Robert Mednick policy. A classic study following this approach DIRECTORS AT LARGE is that by Christina Romer and . [2966] Following in the footsteps of NBER Peter Aldrich Jacob A. Frenkel Michael H. Moskow researchers Milton Friedman and Anna Elizabeth E. Bailey Judith M. Gueron Alicia Munnell John Herron Biggs Robert S. Hamada Rudolph A. Oswald Schwartz and their renowned Monetary History Andrew Brimmer George Hatsopoulos Robert T. Parry of the United States, the Romers read through John S. Clarkeson Karen N. Horn Peter G. Peterson the minutes of the meetings of the Federal Don R. Conlan Judy C. Lewent Richard N. Rosett George Eads John Lipsky Marina V. N. Whitman Open Market Committee to identify episodes Martin Feldstein Laurence H. Meyer Martin B. Zimmerman in which Fed policy switched toward a tougher stance against inflation. They find that after DIRECTORS BY UNIVERSITY APPOINTMENT each of these so-called Romer dates, the econ- omy experienced a substantial decline in pro- , California, Berkeley Marjorie B. McElroy, Duke Jagdish W. Bhagwati, Columbia Joel Mokyr, Northwestern duction and employment. The Romers inter- William C. Brainard, Yale Andrew Postlewaite, Pennsylvania pret their findings as strong evidence for the Michael J. Brennan, California, Los Angeles Uwe Reinhardt, Princeton effect of monetary policy on real economic Glen G. Cain, Wisconsin Nathan Rosenberg, Stanford Franklin Fisher, MIT Craig Swan, Minnesota activity. Saul H. Hymans, Michigan David B. Yoffie, Harvard In another study, Laurence M. Ball looked Arnold Zellner, Chicago at data from OECD countries and found every DIRECTORS BY APPOINTMENT OF OTHER ORGANIZATIONS episode in recent history during which the inflation rate experienced a significant and sus- Mark Drabenstott, American Agricultural Economics Association Gail Fosler, The Conference Board tained decline. [4306] In almost every episode A. Ronald Gallant, American Statistical Association that Ball identified, the country also experi- Richard C. Green, American Finance Association enced a period with output below trend. This is Robert Mednick, American Institute of Certified Public Accountants Angelo Melino, Canadian Economics Association consistent with a short-run tradeoff between Richard D. Rippe, National Association for Business Economics inflation and real economic activity. Ball John J. Siegfried, American Economic Association David A. Smith, American Federation of Labor and Congress of reports that the output effects are smaller (that Industrial Organizations is, reducing inflation is less costly) when the Josh S. Weston, Committee for Economic Development disinflation is rapid and when a country has Gavin Wright, Economic History Association more flexible labor contracts. The NBER depends on funding from individuals, corporations, and private More recent studies on the dynamic effects foundations to maintain its independence and its flexibility in choosing its of monetary policy have taken a very different research activities. Inquiries concerning contributions may be addressed to Martin Feldstein, President & CEO, NBER 1050 Massachusetts Avenue, approach to the data, but they have reached Cambridge, MA 02138-5398. All contributions to the NBER are tax broadly similar conclusions. A common deductible. methodology is to try to identify “monetary The Reporter is issued for informational purposes and has not been reviewed by policy shocks” — movements in some measure the Board of Directors of the NBER. It is not copyrighted and can be freely of monetary policy that cannot be predicted or reproduced with appropriate attribution of source. Please provide the NBER’s Public Information Department with copies of anything reproduced. explained contemporaneously with the eco- nomic variables that typically drive monetary Preparation of the NBER Reporter is under the editorial supervision of Donna policy. These random movements in policy are Zerwitz. interpreted as a natural experiment that can be Requests for subscriptions, changes of address, and cancellations should be used to determine the policy’s effect. Once sent to Reporter, National Bureau of Economic Research, Inc., 1050 Massachusetts Avenue, Cambridge, MA 02138-5398. Please include the cur- these shocks are identified, statistical tech- rent mailing label. niques can be used to trace their effects on

2. NBER Reporter Spring 2003 employment, production, inflation, examined the best methods for fore- wage demands to changes in their pro- and other variables of interest. casting inflation. They conclude that, ductivity. Until workers adapt to the Lawrence J. Christiano, Martin “Inflation forecasts produced by the new environment, a shift in productiv- Eichenbaum, and Charles Evans sum- Phillips curve generally have been ity growth may alter the economy’s marize these studies as follows: “The more accurate than forecasts based on normal level of unemployment. literature has not yet converged on a other macroeconomic variables, Thus, shifts in productivity growth particular set of assumptions for iden- including interest rates, money and impinge on the short-run tradeoff tifying the effects of an exogenous commodity prices.” [7023]. between inflation and unemployment shock to monetary policy. Why, then, did the U.S. economy and, indirectly, on the choices facing Nevertheless, there is considerable experience a rare combination of low monetary policymakers. When produc- agreement about the qualitative effects unemployment and low inflation dur- tivity slows down, as it did during the of a monetary policy shock in the ing the late 1990s? Part of the answer 1970s, monetary policymakers face a sense that inference is robust across a is that the Fed had produced low infla- deteriorating short-run tradeoff large subset of the identification tion during the previous decade, which between inflation and unemployment. schemes that have been considered in in turn made credible monetary policy- When productivity speeds up, as it did the literature.” [6400] This robust con- makers’ claims that they were aiming during the 1990s, monetary policymak- clusion includes the classic textbook for low inflation in the future. Lower ers face an improving tradeoff result that monetary policy first influ- expectations of inflation shift the between these two measures of eco- ences employment and production and short-run tradeoff between inflation nomic performance. only later affects inflation. and unemployment in a favorable The accumulation of many empiri- direction because these expectations The Puzzle of Sluggish cal studies following varied strategies influence the behavior of wage and has led to a consensus among econo- price setters. Inflation mists about how monetary policy Yet lower expectations of inflation affects the key measures of macroeco- are not the whole story behind the Many empirical studies of the infla- nomic performance. The exact timing impressive macroeconomic perform- tion process suggest that inflation is is open to debate, but a rough rule of ance of the 1990s. Part of the answer sluggish. This sluggishness of inflation thumb is that employment and pro- also lies in the widely noted accelera- appears in various guises. In studies of duction respond about six months tion in productivity growth that the Phillips curve, inflation is found to after a change in monetary policy, occurred in the second half of the exhibit substantial inertia; that is, infla- whereas it takes a year or more before decade. As Robert J. Gordon puts it, tion is strongly correlated with its own there is any significant movement in “The post-1995 technological accelera- lagged values. [5735] In studies of par- the inflation rate. tion, particularly in information tech- ticular disinflationary episodes, infla- nology and accompanying revival of tion is found to fall only gradually. The Amazingly Low productivity growth, directly con- [4306] In studies that use statistical tributed both to faster output growth techniques to identify monetary policy Inflation and and to holding down the inflation shocks and their effects, these shocks Unemployment of the rate.” [8771]. are found to have a gradual and The current state of the inflation- delayed effect on the inflation rate. 1990s unemployment tradeoff is often sum- [5146, 6400] Certainly, these conclu- sions are consistent with the conven- During the late 1990s, the United marized in a statistic called the NAIRU, an ugly acronym that stands tional wisdom of central bankers, who States experienced an unusual combi- believe they can influence the inflation nation of low inflation and low unem- for the non-accelerating inflation rate of unemployment. The NAIRU is like rate only with a substantial lag. This lag ployment. In 1999, for instance, the between central bank actions and infla- unemployment rate averaged 4.2 per- a speed limit for the economy, for if the economy grows so fast that unem- tion is one reason why central banks cent for the year, while the inflation that have chosen to target inflation rate as measured by the consumer ployment falls below the NAIRU, inflation tends to rise. Yet the NAIRU often look at expected inflation a year price index was a mere 2.2 percent. To or two ahead when judging whether some casual observers, these fortu- is not constant over time. [5735] In particular, several recent studies have they are on target. itous events suggested that the short- Why does monetary policy influ- run tradeoff between inflation and suggested that an acceleration of pro- ductivity growth will cause the NAIRU ence inflation with such a long lag? unemployment no longer existed, or The answer is not at all obvious. perhaps that it never existed at all. to fall, at least for a while. [8320, 8421, 8614, 8940] The reason for the appar- Standard theories of the real effects of Many NBER researchers have monetary policy emphasize the sticki- rejected this interpretation of the ent link between productivity growth and the NAIRU is very much an open ness of wages or prices. According to recent data. Indeed, the Phillips curve these theories, monetary fluctuations as an empirical phenomenon is still question that should lead to future research. One possible explanation is have real effects in the short run very much alive and well. For example, because wages and prices do not adjust James Stock and Mark Watson have that workers are slow to adjust their NBER Reporter Spring 2003 3. instantly. [For surveys of this topic, see tions, and so on. they are certainly consistent with that 2285, 4677.] Even if this line of Ball has proposed another hypothesis. thought is accepted, however, it fails to approach to this problem. [7988] He explain the sluggishness of inflation suggests that when forming expecta- Rules for Monetary — the change in the price level. The tions of any variable, people optimally stickiness of prices can explain why use all information in the past values Policy the price level does not jump to a level of that variable, but fail to incorporate ensuring full employment, but the information from other variables. That The study of monetary policy aims inflation rate is determined by those is, expectations are based on optimal not only to understand the effects of prices that are changing, and those univariate forecasts. He argues that this central bank actions but also to pro- prices could respond quite quickly to approach to forecasting is nearly duce better monetary policy. Toward changes in monetary policy. Yet for rational, as multivariate forecasts offer this end, a large literature has emerged some reason not found in standard only slight improvement over univari- that studies monetary policy rules. A theories of price adjustment, they ate forecasts. Ball shows that this “near policy rule is a contingency plan that don’t. The failure to explain sluggish rational” approach to expectations can specifies how the central bank will inflation shows that the dynamic explain why inflation appears so slug- respond to varying economic condi- behavior of prices remains a funda- gish in recent data, while it was less tions. mental puzzle for students of business sluggish in data from early in the twen- There are two reasons for interest cycle theory. [7884] tieth century. in monetary policy rules. One reason There have, however, been several In work I have undertaken with put forward by some is recent attempts to explain the slug- , the assumption of that monetary policy might possibly be gishness of inflation. These all depart imperfect information among price better if central banks did not have significantly from standard models of setters is explored from a different discretion but were committed to fol- price setting. But several of the angle. [8290, 8614] We assume that lowing a monetary rule. Some of these attempts are similar in their underlying each period there is a fixed probability economists have argued that central assumptions, and this common struc- that a price setter updates his informa- banks use discretion unwisely and end ture may well point the way toward a tion set; otherwise, he continues to set up being the cause, rather than cure, final resolution of the sluggish-infla- prices based on old plans and outdated for the business cycle. Others argue tion puzzle. The common assumption information. We show that this model that discretionary monetary policy is is that price setters are inattentive: of “sticky information” can explain inherently inflationary. Monetary poli- prices keep rising after changes in why inflation is so sluggish, and that it cymakers often claim that their aim is monetary policy because most price produces dynamic responses to mone- price stability, but once expectations setters are not paying close attention to tary policy similar to those estimated in are formed, they are tempted to renege the policy change and, therefore, keep the empirical literature. on this announcement and take advan- marking up prices as if no change had In all three of these models, infla- tage of the short-run tradeoff between occurred. tion is sluggish because inflation inflation and unemployment. The only One approach to modeling inatten- expectations respond too slowly to way to avoid this time-inconsistency, it tive price setters, explored by Michael changing circumstances. Christopher is argued, is to commit the central Woodford, is to use the tools of infor- Carroll has written an intriguing bank to a policy rule. mation theory and to assume that empirical study that gives some sup- Even if these arguments against humans have a limited channel for port to this prediction. [8695] Carroll discretionary policy are rejected, how- absorbing information. [8673] That is, uses survey data to compare the infla- ever, there is another reason for inter- the human brain is assumed to be tion expectations of the general public est in policy rules — as guidelines for imperfect in the same way as a com- to the inflation expectations of profes- policymakers with discretion. puter with a slow internet connection sional forecasters. He reports three Monetary policymaking is a difficult would be. Woodford uses this assump- notable findings. First, he confirms business, and policymakers are always tion to build a model of inflation that professional forecasters are better eager to hear objective, reasoned dynamics. His model can explain slug- at forecasting inflation than is the gen- advice on how to respond to econom- gish inflation, as well as the persistent eral public. Second, he finds that the ic conditions. A policy rule that per- effects of monetary policy on output. public responds to the professionals’ forms well by some criterion can be He emphasizes that because not every- expectations with a lag that averages viewed as such advice. one shares the same information, price about one year. Third, he reports that There is a large literature that uses setting depends on “higher order when the news media are producing the tools of modern monetary theory expectations.” That is, price setters more stories about inflation, the pub- to derive optimal policy rules. An care about not only their own expecta- lic’s expectations adjust more quickly excellent introduction to this literature tions of monetary policy, but also their to the professional forecasts. These is a paper by Richard Clarida, Jordi expectations of others’ expectations, findings do not prove that the slug- Gali, and , with the allur- and their expectations of others’ gishness of inflation is attributable to ing title “The Science of Monetary expectations of still others’ expecta- the inattentiveness of price setters, but Policy: A New Keynesian Perspective.”

4. NBER Reporter Spring 2003 [7147] One conclusion from this liter- obey the “Taylor principle,” which Taylor principle. [6442, 6768, 8471, ature is that optimal policy can often states that the nominal interest rate 8800] That is, the Fed has responded be written as a form of a “,” should rise more than one-for-one aggressively to changes in inflation according to which the short-term with the inflation rate. In many stan- when choosing its target interest rate interest rate set by the central bank dard models of the business cycle, this during the recent period, whereas the responds to inflation and a measure of principle ensures that shocks to the Fed appears to have responded much real economic activity, such as the economy do not induce inflation to get less to inflation in the earlier period. deviation of output from its potential. out of control. There is considerable This insufficient response to inflation [For a recent example, see 9149; for an evidence that the successes of mone- may explain why inflation got out of opposing view, see 9421.] tary policy over the two decades, com- hand in the United States in the 1970s. Another conclusion from this liter- pared to the problems in the 1970s, ature is that optimal policy should can be explained by reference to the

Research Summaries

Explaining Exchange Rate Behavior

Menzie D. Chinn*

In an era characterized by increas- rates, an enterprise separate from fore- this type of model.3 In addition, the ingly integrated national economies, casting exchange rates. model typically is applied to economies the exchange rate is the key relative experiencing rapid growth, since such price in open economies. As such, a growth often is associated with rapid great deal of attention has been The Impact of productivity change in the tradable focused on characterizing its behavior. Productivity Changes (manufacturing) sector. Hence, a natu- Unfortunately, it is unclear how much ral application of the model is to the success there has been in predicting The first major line of inquiry I’ve East Asian countries. Unfortunately, this critical relative price. As recently followed links changes in productivity the data necessary for a direct test of remarked, “There may be more fore- to changes in nominal and real the model do not readily exist. Instead, casting of exchange rates, with less exchange rates. There is a long and most analyses rely on observations on success, than almost any other eco- venerable literature that links these two relative prices to infer the validity of nomic variable.”1 While this characteri- variables theoretically, most notably the approach. In order to conduct a zation may be quite apt — a point I associated with Balassa and direct test, I compiled sector-specific will return to later — it should not pre- Samuelson.2 In these models, differ- employment and output data for vent us from attempting to identify the ences in productivity levels between China, Indonesia, Japan, Korea, empirical determinants of exchange traded and nontraded sectors affect Malaysia, Philippines, Singapore, the relative prices of these goods. Taiwan, and Thailand, and estimated Further, with traded goods prices the implied relationships. The time- * Chinn is a Research Associate in the equalized in common currency terms, series evidence did not support the NBER’s Program on International Finance real exchange rates — which incorpo- model except in a few cases. Using and Macroeconomics and an Associate rate the prices of nontraded good — panel regression techniques adapted to Professor of Economics at the University of will be affected. persistent time series,4 I find that the California, Santa Cruz. His profile appears The post-War yen has been the tra- model applies to the set of countries later in this issue. ditional candidate for explanation by including Indonesia, Japan, Korea,

NBER Reporter Spring 2003 5.