The Science and Practice of Monetary Policy Today

Michael Woodford has contributed so much important and path-breaking research that it would be impossible to cover all of it in this talk. Also, I have had a difficult time knowing whether to speak about his contributions or about the New-Keynesian approach more generally. So I will start with neither of these and instead try to tell a bit about Woodford as a person, but from a professional perspective. I believe that I first met him in 1985 at a research conference in Austin, Texas, where we were both presenting papers on monetary economics conducted in overlapping generation (OG) models. I was, at the time, having arguments with some economists who had been deriving several startling results in OG models, basically because their setups gave “money” no medium-of-exchange properties — it provided no transaction-facilitating services to its holders. It also paid no interest, so if the model economy included capital or land no one would want to hold any money unless prices were falling rapidly enough. I thought that this was a foolish approach, but was very nervous about making the argument because these other economists were quite prominent — and I feared that Michael would support their position. Well, it turned out that his model did give money a medium-of-exchange role, so that was fine with me.¹ That was my first indication that Woodford rarely (if ever) does anything that is truly foolish.

The New-Keynesian (NK) approach to monetary policy analysis has emerged in recent years as one of the most influential and prolific areas of research in macroeconomics.¹ It has provided us with a framework that combines the theoretical rigor of Real Business Cycle (RBC) theory with Keynesian ingredients like monopolistic competition and nominal rigidities. That framework has also become the basis for the new generation of models being developed at central banks, and increasingly used for simulation and forecasting purposes.² In the present chapter, I will try to summarize what I view as some of the key lessons that have emerged from that research program and to point to some of the challenges it faces, as well as possible ways of overcoming these challenges.

At central banks around the world, forecasts have come to play an increasingly important role both in policy deliberations and in communications with the public. The most striking examples are the Bank of England, Sweden's Riksbank, Norway's Norges Bank, and the Reserve Bank of New Zealand, all of which conductpolicy on the basis of a procedure sometimes referred to as “inflation-forecast targeting” (Svensson, 1997, 1999). Under this approach, the central bank constructs quantitative projections of the economy's expected future evolution based on the way in which it intends to control short-term interest rates, and public discussion of those projections is a critical part of the way in which the bank justifies the conduct of policy to the public.

This volume celebrates the work of Michael Woodford and his many contributions to economics.

One of Mike's most influential papers is the 1997 paper (co-authored with Julio Rotemberg) “An optimization-based econometric framework for the evaluation of monetary policy.” This paper constituted the first attempt at estimation of a small scale dynamic stochastic general equilibrium model (DSGE) in which prices are set by monopolistically competitive firms, and prices cannot be instantaneously and costlessly adjusted. Since the work of Rotemberg and Woodford, these models have become more complex and increasingly large [see Christiano, Eichenbaum and Evans (2005), Smets and Wouters (2003), and, more recently, Christoffel, Coenen and Warne (2008) and Adolfson, Laséen, Lindé and Svensson (2008)]. By explicitly taking into account forwardlooking behavior on the part of the agents, DSGEs provide a useful framework to analyze the effects of alternative policies. These models are now routinely used in many central banks, including the European Central Bank, and knowledge has been built up on their reliability, their forecasting performance and on what are the reasonable values for calibrated parameters and the setting of the priors.

The notion that inflation is a monetary phenomenon is a central tenet of monetary economics. It implies that inflation is ultimately a consequence of monetary policy, and the same conclusion is applied to deflation. This view is usually motivated by the quantity theory. The quantity theory states that sustained increases or decreases in the overall price level occur along with faster or slower growth rates of monetary aggregates adjusted for long-run output and velocity trends. On the basis of this theory, central banks have at times assigned an important role to monetary aggregates in the formulation of monetary policy. For example, the U.S. Federal Reserve emphasized the role of monetary aggregates when Chairman Paul Volcker set out to overcome the great inflation in the United States in 1979. Perhaps, he was partly following the earlier example of the German Bundesbank that had been more successful in fighting the inflationary impetus of the 1970s oil price shocks with the help of monetary targets.

Over the past three decades, we have seen a remarkable change in the performance of monetary policy. By the end of the 1970s, inflation had risen to very high levels, with many countries in the Organisation for Economic Co-operation and Development (OECD) experiencing double-digit inflation rates (Figure 1). Most OECD countries today have inflation rates around the 2 percent level, which is consistent with what most economists see as price stability, and the volatility of inflation has also fallen dramatically (Figure 2). One concern might be that the low and stable levels of inflation might have been achieved at the expense of higher volatility in output, but that is not what has occurred. Output volatility has also declined in most OECD countries (Figure 3). The improved performance of monetary policy has been associated with advances in the science of monetary policy, that is, a set of principles that have been developed from rigorous theory and empirical work that have come to guide the thinking of monetary policy practitioners.

In this chapter, I will review the progress that the science of monetary policy has made over recent decades. In my view, this progress has significantly expanded the degree to which the practice of monetary policy reflects the application of a core set of “ scientific” principles. Does this progress mean that, as Keynes put it, monetary policy will become as boring as dentistry — i.e., that policy will be reduced to the routine application of core principles, much like filling cavities?¹ I will argue that there remains, and will likely always remain, elements of art in the conduct of monetary policy; in other words, substantial judgment will always be needed to achieve desirable outcomes on both the inflation and employment fronts.

It is a great honor to welcome you here today to the award ceremony of the Deutsche Bank Prize in Financial Economics 2007, and in particular, to have an opportunity to congratulate the prize-winner Professor Michael Woodford. As most of you know, this is the second time we are celebrating this prize here at Villa Sander, following the award to Professor Eugene Fama two years ago.

Before I start, I would first like to thank all those who have made this event possible, most notably Professor Volker Wieland from the University of Frankfurt and the Center for Financial Studies, who served as the chairman of this year's jury and will be addressing you shortly. I would also like to thank the members of the jury, who spent a considerable amount of time and effort on selecting the winner from among the many high quality recommendations that they received. It is indeed an impressive jury, consisting of outstanding academics and central bankers, as well as a journalist and Deutsche Bank's Chief Economist.

I am very happy to welcome you on behalf of the Center for Financial Studies at Goethe University to this symposium in honor of the recipient of the Deutsche Bank Prize in Financial Economics 2007. This year marks the second time the prize is awarded.

This prize, established by Goethe University and the Center for Financial Studies, aims to honor an internationally renowned researcher who has excelled through influential contributions to research in the fields of finance and money and macroeconomics, and whose work has led to practice – and policy-relevant results.

It is a great pleasure for me to welcome you all in Frankfurt today. First of all, I would like to thank Professor Michael Woodford for accepting the Deutsche Bank Prize in Financial Economics 2007 that will be awarded to him at a ceremony later on. And I would like to thank him for joining this symposium on the “ Theory and Practice of Monetary Policy Today”I am truly pleased that the second Deutsche Bank Prize in Financial Economics serves again as an occasion for a scientific symposium: An event that brings together first-rate experts of finance from academia and the corporate world.

The Deutsche Bank Prize in Financial Economics is the most highly endowed international award given for outstanding academic achievements in the fields of money and finance with a practice and policy relevant orientation. It was established in 2005 by the Center for Financial Studies, in cooperation with Frankfurt University. The prize is sponsored by the Deutsche Bank Donation Fund and carries a cash award of € 50,000. It is awarded every two years.

The Deutsche Bank Prize for 2007 was awarded to Michael Woodford, Professor of Political Economy at Columbia University. Woodford received the prize in recognition of his fundamental contributions to the theory and practical analysis of monetary policy. According to the international prize jury, Woodford's research has led to a theory of monetary macroeconomics that holds widespread appeal for many researchers owing to its rigorous microeconomic foundations. The jury also praised the high practical value of Woodford's theories, based on which he analyzes the central role played by expectations and communication in the implementation of monetary policy.

Monetary policy is and remains a challenging policy area — even if the calm monetary environment at the moment may be taken to suggest that things are running according to plan. Monetary history shows us that just when we start to believe we had arrived at a stable routine of keeping inflation at bay, new issues for monetary policy arise. Monetary policy is all about expectations, and “expectations” means past developments plus an error term. It is the error term that all of us are most interested in — unexpected risks, our failure to assess future developments. And this is why discussions between academics and market practitioners, like on this panel, are so important. Let me address four key issues that I believe will occupy us in the future: