Miller, Μ. & Zhang, L. (2014) “To exit the Great Recession, central banks must adapt their policies and models“, VoxEU Organisation, 10 September.
During the Great Moderation, inflation targeting with some form of Taylor rule became the norm at central banks. This column argues that the Global Crisis called for a new approach, and that the divergence in macroeconomic performance since then between the US and the UK on the one hand, and the Eurozone on the other, is partly attributable to monetary policy differences. The ECB’s model of the economy worked well during the Great Moderation, but is ill suited to understanding the Great Recession.
“Practical men…are usually the slaves…[of] some academic scribbler of a few years back” – John Maynard Keynes.
For monetary policy to be most effective, Michael Woodford emphasised the crucial importance of managing expectations. For this purpose, he advocated that central banks adopt explicit rules for setting interest rates to check inflation and recession, and went on to note that:
“[such] rule-based policy making necessarily means a decision process in which an explicit model of the economy…plays a central role, both in the deliberations of the [central bank’s] policy committee and in explanation of those deliberations to the public.” (Woodford 2003: 18).
During the period of the Great Moderation (circa 1983 to 2007), central banks were by-and-large persuaded to follow this advice and to adopt the sort of New Keynesian macroeconomic model Woodford had specified. Inflation targeting, with some variety of Taylor rule for interest rates to achieve this, became the norm. But the forward-looking, rational-expectations model Woodford used provided no warning of the financial crisis that was to erupt in 2008/9 – such events had effectively been ruled out by the assumption of efficient financial markets and the omission of money and banking.
Relevant posts:
- Barwell, R. & Chadha, J. (2014) “Publish or be damned or why central banks need to say more about the path of their policy rates“, VoxEU Organisation, 31 August.
- Claeys, G. (2014) “The (not so) Unconventional Monetary Policy of the European Central Bank since 2008“, Policy Department A for the Monetary Dialogue discussions in the Economic and Monetary Affairs Committee (ECON) of the European Parliament, 09 July.
- Visco, I. (2013) “The aftermath of the crisis: Regulation, supervision and the role of central banks“, Policy Insight No.68, Centre for Economic Policy Research, December.