Measuring Systematic Monetary Policy

The 1970s and early 1980s witnessed two main approaches to the analysis of monetarypolicy. The first is the early new classical approach of Lucas, based on the assumptionsof rational expectations and market clearing. The second is the atheoretical econometricsof Sims?s VAR program. Both have developed: the new classical approach has beenenriched through various accounts of price stickiness, cost of adjustment or alternativeexpectational schemes; the original VAR program has developed into the structural VARprogram. This paper clarifies the relationship between these two programs. Based onwork of Cochrane (1998), it shows that the typical method of evaluating unanticipated,unsystematic monetary policy is correct only if the conditions necessary for Lucas?spolicy-ineffectiveness proposition hold, while recent methods for evaluating systematicmonetary policy violate Lucas?s policy-noninvariance proposition (?the Lucas critique?).The paper shows how to construct and estimate (using regime changes) a model in whichsome agents form rational-expectations and others follow rules of thumb. In such amodel, monetary policy actions can be validly decomposed into systematic andunsystematic components and valid counterfactual experiments on alternative systematicmonetary-policy rules can be evaluated.