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10 CHOICES Fourth Quarrer 1997

by John B.Taylor

ACore ofPractical

MacroeconomicsM acroeconomics-the part of economics thatfocuses on economic groWTh and economicfluctuations-has always been an area of great controversy and debate. Over 150 years ago DavidRicardo argued with Thomas Malthus over the importance of supply versus demand in growth andfluctuations, much as real-business-cycle economistshave argued with monetarists and Keynesians inrecent years. The Keynesian revolution of the 1930sand the rational-expectations revolution of the1970s, both questioning macroeconomic ideas ofthe time, were rwo of the most contentious episodes in the history of economic thought. Someview recent macroeconomic debates as so intensethat they see macroeconomics as nothing more thancompeting camps of economists with no commonset of core principles.

In my view, there is aset of key principles-acore-of macroeconomics about which there iswide agreement. Thiscore is the outgrowth ofthe many recent debatesabout Keynesianism,monetarism, neoclassicalgrowth theory, real-business-cycle theory, and rational expectations. Thecore is practical in thesense that it is having abeneficial effect on macroeconomic policy, especially monetary policy,and has resulted in improvements in policy inthe last fifteen years . Infact, new econometric

models recently pu t in operation at the Fed largelyreflect this core. This core is increasingly evident inundergraduate economics texts, and it also appearsin graduate training, though in most PhD programs there is much more emphasis on the newerand more controversial parts.

Although there are different ways to characterizethis core, I would list five key principles. I wouldstart with the most basic and least controversialprinciple, focusing on long-term economic growthand the supply side of the economy. Over the longterm, labor productivity growth depends on thegrowth of capital per hour of work and on thegroWTh of technology or, more precisely, on movements along as well as shifts of a production function, as Robert Solow pointed out many years ago.

If one adds to this labor productivity growthan estimate of laborforce growth, one getsan estimate of the longrun groWTh rate of realGDP, or what is typically referred to as potential GDP growth.This principle, the essence of neoclassicalgrowth theoty, providesa way to estimate anddiscuss the sources oflong-term economicgrowth within the organizing structure ofthe groWTh accountingformula. Key policyquestions to addresswithin this framework,of course, are why po-

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tential GOP growth has declined and what can bedone to raise it again.Is this first principle practical? Yes. Public policy

economists at the Fed and the Congressional Budget Office and private industry economists regularly use this approach to get estimates of potentialGOP growth. Most now estimate this growth to beabout 2-2.5 percent per year. Of course there aredebates about how to apply this principle: Are therediminishing returns to information capital? Howmuch would fundamental tax reform raise the capital-labor ratio? How much does a reduction in marginal tax rates increase labor supply? But these aremore quantitative issues, concerning the size of elasticities, rather than matters of principle.

A second key macroeconomic principle is thatthere is no long-term trade-off between the rate ofinflation and the rate of unemployment; a corollary is that a shift by the central bank to a higherrate of money growth will simply result in moreinflation in the long run, with the unemploymentrate remaining unchanged. Although controversialat one time, this does not appear to be controversial anymore; empirical and theoretical research provides strong support. In the 1960s inflation waslow, and unemployment was between 5 percentand 6 percent; in the 1970s inflation was high, andunemployment was no lower; and in the 1990sinflation is low again, and unemployment has notincreased. There are two qualificat ions to this principle: (i) international evidence from different counuies indicates that high rates of inflation appear toreduce the g r o ~ of potential GOP, and (ii) verylow rates of inflation, in particular deflation, maybe an impediment to the smooth operation ofmarkets, both because of a lower bound on the nominal interest rate and because of the stickiness ofprices and wages.

This second principle already has had a majorpractical impact on policy. It implies that centralbanks should pick a long-run target range for inflation and stick with it. Many cenual banks aroundthe world are doing just that, either explicitly, aswith New Zealand and the United Kingdom, orimplicitly, as with the United States and Germany.A third principle is that there is a short-run tradeoff between inflation and unemployment. In myview this trade-off is best described as one betweenthe variability of inflation and the variability ofunemployment. There is still debate about the reason for this trade-off. One ratio nale is the stickyprice/staggered-wage theory, which I favor; but thereis also the information-based theory put forth byRobert Lucas. There is also an ongoing debate aboutthe monetary transmission mechanism: Does monetary policy work through a money channel, a creditchannel, or through a financial price channel (in-

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terest rates and exchange rates)?Despite these debatable underp innings, the ex-

istence of a short-run trade-off has practical implications for policy: monetary policy should keep thegrowth of aggregate demand stable in order to prevent fluctuations in real output and inflation . Infact, the improvements of monetary policy duringthe last fifteen years have led to much more stablemacroeconomic conditions. The United States isnow experiencing, back to back, the two longestpeacetime expansions (1982-90 and 1991-97) inU.S. history, separated by one of the mildest recessions in U.S. history (1990-91). A greater stabilityof monetary policy, including explicit discussionsand actions consistent with the goal of keeping inflation low, is largely responsible for this recordbreaking macroeconomic stability. Every recessionsince the 1950s has been preceded by a run-up ofinflation; by keeping inflation from rising in thefirst place, the chances of such recessions are diminished.A fourth macroeconomic principle is that people'sexpectations are highly responsive to policy, and,thus, expectations matter for assessing the impactof monetary and fiscal policy. The most feasibleempirical way to model this response or endogeneityof expectations is the rational-expectations approach,though modifications to take account of differingdegrees of credibility are necessary. By inuoducingrational expectations into fully estimated econometric models and then simulating the models for different policies, the response of expectations tochanges in policy can be reasonably approximated(see Taylor).

Is this fourth principle having an impac t on practice? Yes. For example, macroeconomic models withrational expectations now in use at the Fed are ableto estimate the effects on interest rates of a multiyearplan to reduce the future budget deficit (see Braytonet al.). These models can help guide monetary decisions about interest rates when a plan for budgetdeficit reduction (like that in 1990 or 1993 in theUnited States) is being considered. Additional evidence for the practical relevance of this principle isthe great emphasis placed on credibility by centralbanks today. According to rational-expectationsmodels, there are advantages to credibility in bothmonetary policy and fiscal policy. For example, adisinflation will have lower short-run costs if policyis credible. Similarly, a plan to reduce the budgetdeficit will have a smaller shorr-run contractionaryeffect if it is credible.

A fifth principle is that when e v a l u a t i ~ g monetary and fiscal policy one should think not in termsof a one-time isolated change in the instruments ofpolicy but rather as a series of changes linked by asystematic process or a policy rule. This fifth prin-

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12 CHOICES Fourth Quarter 1997

John B. Tayloris director of theCenter forEconomic PolicyResearch and isRaymondProfessor ofEconomics atStanfordUniversity.

ciple follows from many of the other principles. Itis quite evident in academic policy-evaluation research during the past fIfteen years, where virtuallyall formal policy evaluation has been done in termsof policy rules. To be sure, there is debate aboutthe form of the policy rules: Should the interestrate or the money supply be the instruments in therule? Should the instrument react to the exchangerate or solely to inflation and real output? Howlarge should the reaction of policy be to inflation?Is the rule a guideline or should it be legislated andused to add accountability to policy making?

Recently there has been increased practical interest in policy rules . For example, in recentspeeches, Federal Reserve Board Governors LaurenceMeyer (1996) and Janet Yellen (1996) have described in detail how policy rules can be helpful inthe formulation ofmonetary policy. Speaking abouther practical experience on the Federal ReserveBoard, Ye llen states that " .. . rules proved a simpleuseful benchmark to assess the setting of monetarypolicy in a very complex and uncertain economic. "environment.

The Federal Reserve Board staff now uses stochastic simulation of alternative policy rules on aregular basis. And many private-sector businesseconomists have noted the similarity between theactions of the Fed and many other central banks tothe outcomes implied by certain policy rules.

In conclusion, let me emphasize that this characterization of a core of practical macroeconomicsis not meant to imply that everything is settled inmacroeconomics. On the contrary, there are stillgreat debates going on over the size of elasticities,the ro le of credit in the monetary transmissionmechanism, the empirical relevance of "endogenous"growth models, whether staggered price-settingmodels with rational expectations fit satisfactorilythe dynamic correlations that characterize the pro-

cess of inflation in the United States, and manyother issues.

One question that wi ll continue to be debatedfor many years is how much formal optimizatio n isappropriate in order to provide a solid underpinning to macroeconomics. Many of the macroeconomic models I referred to in this discussion areeconomywide, general-equilibrium models whichhave sticky-price equations as part of their structure; but there is still much more work to be doneto fully establish the optimization basis for many ofthese sticky-price structures. The current effort to Iincorporate money and sticky prices into real-bus i-ness-cycle models will hasten the day when modelswith a more fully articulated optimization structureare used in practice for policy making. I believe thatthis work will add much to economists' understanding of the macroeconomic principles summarized inthis discussion, but in the meantime, there is a solidcore of macroeconomic principles which is useful inpractical policy work and which has already improvedmacroeconomic policy making in the United Statesand other countries. [! l For more informationBrayton, F., A. Levin, R. Tryon, andJ. Williams. "TheEvolution of Macro Models at the Federal ReserveBoard." Carnegie Rochester Series on Public Policy, forthcoming 1997.Meyer, L.H. "Monetary Policy Objectives and Strategy." Remarks befo re the National Association ofBus i-ness Economists, 38th an nual meeting, Board of Gov

e r n o r ~ o f the Federal Reserve System, Washington DC,8 September 1996.Taylor, J.B. Macroeconomic Policy in a World Economy.New York: Norron, 1993.Yellen, J . "Monetary Policy: Goals and Strategy." Remarks before the National Association of BusinessEconomists, Board ofGovernorsof the Federal ReserveSystem, Washington DC, 13 March 1996.This article is reprinted from the American EconomicReview, May 1997, pages 233-35, and is published herewith permission of the author and the American Economics Association.