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Book Review

Comptes rendus / Reviews

Evan F. Koenig, Robert Leeson and George A. Kahn (eds.), The Taylor Rule and the Transformation of Monetary Policy

Stanford: Hoover Institute Press, 2012, xix + 345 pages, ISBN 978-817914042

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Michel De Vroeya1

a1 University of Louvain.
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Few economists have experienced the honor of seeing their name associated with a law or basic principle during their lifetime. Lucas and Taylor are members of this small club, the first for the “Lucas Critique”, the second for the “Taylor Rule”. Proposed by Taylor at the Carnegie-Rochester Conference on Public Policy in November 1992 (Taylor, [1984]993), the Taylor rule has become a staple of monetary theory.

The Taylor Rule and the Transformation of Monetary Policy is a Festschrift in honor of Taylor. Twenty years after Taylor’s inaugural paper it testimonies for the lasting impact of this rule on monetary theory and policy. When introducing what was to become the Taylor rule in his 1992 Carnegie-Rochester Conference paper, Taylor presented it modestly as a “hypothetical but representative policy rule that is much like that advocated in recent research” (Taylor, 1993, 197). A reaction function, the Taylor rule has the short-period nominal rate of interest of the central bank as its policy instrument. According to Taylor, this rate ought to be set in reaction to two variables: first, the difference between the observed inflation rate and the target rate of inflation (the inflation gap) and second, the difference between effective and potential output (the output gap). Taylor proposed to give equal weight to the stabilization of inflation and output. As he formulated it, the rule recommended a 0.5 percent decrease of the FED funds rate whenever real GDP was 1 percent below potential GDP. He posited the target inflation rate at 2 percent, recommending a rise in the interest rate by 0.5 percent in case the actual rate of inflation overtook the target rate by 1 percent.

In this inaugural paper, Taylor underlined the descriptive performance of his rule—“What is perhaps surprising is that this rule fits the actual policy performance during the last few years remarkably well” (Taylor, 1993, 202). However, what started as positivistic observation was (gradually) transformed into a policy prescription. One implication of the rule was to propose a new trade-off, which became encapsulated in the so-called “Taylor’s curve”, a trade-off between the variability of output and that of inflation. It replaced the ancient Phillips curve trade-off between the unemployment rate and the inflation rate. While the Phillips trade-off could only be temporary, the Taylor trade-off was claimed to be permanent. As noted by Chatterjee, amongst others, “the central idea underlying Taylor’s variability-based trade-off is that policymakers can choose the degree to which monetary policy is used to buffer the unemployment rate against non-fundamental disturbances.” (Chatterjee, 2002, 29)

Most of the papers in The Taylor Rule and the Transformation of Monetary Policy were presented at a conference that was held at the Federal Reserve Bank of Dallas in October 2007. Its editors are Evan F. Koenig, a Vice President and Senior Policy Advisor of the Federal Reserve Bank of Dallas, George Kahn, a Vice President and Economist at the Federal Reserve Bank of Kansas City, and Robert Leeson, a visiting professor of economics at Stanford University. The first two moved from academics to central banking. The third one, a historian of economics, is a specialist of Phillips and Friedman.

Part I of the book comprises four chapters. In Chapter 1, Pier Francesco Asso and Robert Leeson offer a detailed history of economics survey entitled “Monetary Policy Rules: From Adam Smith to John Taylor.” This chapter aptly reminds the reader that the rules-versus-discretion debate goes a long way back in history, taking its modern shape in the mid 19th century dispute between the Currency and Banking schools. Chapter 2, “The Taylor Rule and the Practice of Central Banks” by Georges Kahn, does an excellent job in presenting the content and working of the Taylor rule. Kahn’s chapter brings out one of Taylor’s distinctive traits, namely that, more than others, he proved able to bring together academics and central bank economists at a time when they tended to be on different planets. As put by Asso, Kahn and Leeson, the Taylor rule offered “a compromise between academic complexity and policy-influencing simplicity” (Asso, Kahn & Leeson 2007, 4). Beyond doubt, Taylor’s desire to think about economic policy both in theory and in practice explains his going back and forth between academic positions (Princeton and Stanford) and spans in the policy apparatus (two terms at the Council of Economic Advisers, Research Adviser at the Philadelphia Federal Reserve Bank, and Undersecretary for International Affairs at the US Department of Treasury under the G. W. Bush administration). In Chapter 3, Edward Nelson compares the theoretical views of Friedman and Taylor, emphasizing their similarities rather than their differences. I, for one, would bend towards the opposite interpretation. Admittedly, Friedman and Taylor both emphasize the role of money in the economy and have moved the pendulum from discretion towards rules. They also share affinities when it comes to policy. Nonetheless, they differ substantially. As is well known, the main distinction between them pertains to the content of the rule they assign to central banks: Taylor replaced Friedman’s constant growth of money supply rule with an interest rate feedback rule. Both are rules but they are based on different instruments. Moreover, while the constant growth of money supply has a ring of automatism attached to it, in Taylor’s conception, a rule ought to react to events: “A policy rule is a description of how the instruments of policy should be changed in response to observable events.” (Taylor, 2000, 8) This variance is furthermore underpinned by a broader methodological difference. This is the case not only for the modeling strategy (including their opinion about the rational expectations assumption) but also for what concerns price and wage formation. Friedman had no qualms about adopting the assumption of prices and wages flexibility (to the point of asserting that its empirical verification had spelled the defeat of Keynesian theory). On the contrary, Taylor regards sluggishness as a basic fact of life that theory cannot put under the rug. Lucas’ short piece in Chapter 4 is an elegant eulogy of Taylor’s contribution.

Part II, entitled “From the Great Moderation to the Great Deviation”, comprises three chapters reflecting on business fluctuations in developed countries over the last decades. In my eyes, they constitute the most interesting part of the book. In the first of these chapters, entitled “The Great Moderation”, Bernanke probes three possible causes of the substantial decline in macroeconomic volatility during the past twenty years: structural changes, improvements in monetary policy and good luck. He concludes that the second of these factors carries the main responsibility for the great moderation. In the second chapter, entitled “The Great Deviation,” Taylor reflects on the era that followed the great moderation and which he dubs the “great deviation”. To him, the policy followed by the FED from 2002 to 2006 ought to be indicted for its lack of applying the Taylor rule! The housing boom and bust as well as the subsequent crisis, he claims, are the consequence of this mistaken monetary policy. Finally, in the last chapter, entitled “It is not that Simple,” Donald Kohn somewhat distances himself from the Taylor rule, highlighting different elements that make its use problematic. For example, he wonders which of the many possible price indexes should be used and points out the difficulty of determining the level of the equilibrium real interest rate and the level of potential output.

Part III is a discussion of forecast targeting as a monetary policy strategy. It comprises three articles authored by Michael Woodford, Taylor and Lars Svensson. Unlike the other parts of the volume, these chapters are specialized and highly technical. Woodford opens fire by proposing a new criterion for optimal monetary policy. According to him, central banks must commit themselves to make current and future instrument-setting compatible with a forecast-target criterion. Taylor is hardly enthusiastic about Woodford’s suggestion. His rule, he claims, is a simpler and more intuitive way of achieving the same strategy. Svensson, for his part, insists on inflation targeting.

Finally, Part IV consists of a series of assessments of Taylor’s work by eminent policy officials: Ben Bernanke, Janet Yellen, Otmar Issing and John Lipsky. The book ends with an Appendix, entitled “The Pursuit of Policy Rules: a Conversation between Robert Leeson and John B. Taylor,” in which Leeson invites Taylor to comment on the different steps of his career and the rationale behind the theoretical bifurcations he engaged into.

A recurrent feature of books published in honor of a retiring professor is that they lack unity. This is not the case for this collection. However, like most Festschrift works, it hardly blazes new trails and its contributions are unequal. Moreover, what may be missing is an attempt at describing Taylor’s place in the history of modern macroeconomics. Taylor’s interview with Leeson is a first step in this process but an outside account would have been useful. Here are a few elements that could be brought to the forefront.

A first trait that should be underlined is that, from his first writings to the present, Taylor holds the strong conviction that sluggishness is a basic fact of life that needs to be part of any valid model. “Perfectly flexible prices and market clearing was something that made little sense to me.” (Taylor interview by Snowdon and Vane 1989, 186) Another feature worth mentioning is that Taylor was among the first macroeconomists to endorse the rational expectations assumption. What he refused, however, was the policy inefficiency conclusion that Sargent and Wallace drew from its adoption. His motivation when constructing his staggered wage contracts model was to show that the linchpin of Sargent and Wallace’s conclusion was the flexible prices rather than the rational expectations hypothesis. A third trait is that to Taylor policymaking—monetary rather than fiscal policy—ought to be the central concern of macroeconomics. To him, any model that has no precise policy conclusion is of little interest. This is the basis for his dismissal of many new Keynesian models such as menu costs or models such as efficiency wages models that aim at demonstrating the existence of involuntary unemployment but lack any precise policy conclusion (Snowdon and Vane, 1989, 198). The long-term objective of policymaking, in his eyes, is to keep inflation steady and low thereby avoiding disturbances in the real economy:

The task of monetary policy is to keep inflation close to the target without causing large fluctuations in real output or employment. (Taylor, 2000, 9)

By responding to economic shocks in a systematic fashion, economic policy can offset their impact or influence the speed at which the economy returns to normal. It can thus change the size of the fluctuations. (Taylor [1984] 1986, 159)

The relationship of Taylor to RBC modeling is also worth pondering upon. In RBC models, money is conspicuous by its absence. Nor is there any room for sluggishness. Small wonder then that, to Taylor, the 1980s, during which the RBC modeling held sway, were a “dark age” (Taylor, 2007):

While I was surprised that sticky wage or price rational expectations models didn’t catch on more quickly, what surprised me even more was the way that models with money and monetary policy in them (both sticky and flexible price rational expectations models) were abandoned for real business cycle models which excluded money entirely. (Snowdon and Vane, 1989, 197)

I find this extreme view [the RBC view] far from reality. Even if we ignore the evidence of Friedman and Schwartz for the Great Depression in the US there seem to be problems with the extreme business cycle view. I find it difficult to explain the 1981-82 recession without a reference to the role of the Federal Reserve Board in attempting to reduce the rate of inflation. I also find it difficult to explain difference between economic fluctuations in the US and Japan without reference to differences in nominal wage rigidities and monetary policy. Finally, there are other factors about the business cycle, the correlations between prices and output, that the real business cycle models cannot explain. (Taylor, 1989, 188)

No surprise either that Taylor regards the ascendance of DSGE modeling, wherein money and sluggishness return to the forefront, as a renaissance. These factors integrated, his judgment about RBC modeling became more positive as he acknowledged that it marked a significant methodological breakthrough. The table below summarizes how Taylor fares with respect to other important macroeconomists on the score of a few significant benchmarks.



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