IDEAS home Printed from https://ideas.repec.org/p/fip/fedbwp/98-5.html
   My bibliography  Save this paper

Dynamic inconsistencies: counterfactual implications of a class of rational expectations models

Author

Listed:
  • Arturo Extrella
  • Jeffrey C. Fuhrer

Abstract

A number of recent papers have developed dynamic macroeconomic models that incorporate rational expectations and optimizing foundations. While the theoretical motivation behind these models is sound, the dynamic implications of many of the specifications that assume rational expectations and optimizing behavior can be seriously at odds with the data, for both inflation and real-side variables exhibit gradual and "hump-shaped" responses to real and monetary shocks. For models that are intended for monetary policy analysis, these dynamic shortcomings should be considered quite serious. When monetary policy has only short-run effects on real variables, the inability to approximately capture the short-run responses of inflation or real variables to policy shocks makes a model unsuitable for policy analysis. This paper identifies a simple feature common to many dynamic specifications for prices and real variables that causes the problem. The paper also discusses several potential solutions to the problem, including alterations to the expectations assumption, to the order of differencing implicit in the model, and to the underlying behavioral assumptions.

Suggested Citation

  • Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:98-5
    as

    Download full text from publisher

    File URL: http://www.bostonfed.org/economic/wp/wp1998/wp98_5.htm
    Download Restriction: no

    File URL: http://www.bostonfed.org/economic/wp/wp1998/wp98_5.pdf
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
    2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1994. "Identification and the effects of monetary policy shocks," Working Paper Series, Macroeconomic Issues 94-7, Federal Reserve Bank of Chicago.
    3. Christopher A. Sims, 1986. "Are forecasting models usable for policy analysis?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-16.
    4. Jeffrey C. Fuhrer, 1998. "An Optimising Model for Monetary Policy Analysis: Can Habit Formation Help?," RBA Research Discussion Papers rdp9812, Reserve Bank of Australia.
    5. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
    6. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, vol. 90(3), pages 341-355, June.
    7. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    8. Bennett T. McCallum & Edward Nelson, 1999. "Performance of Operational Policy Rules in an Estimated Semiclassical Structural Model," NBER Chapters,in: Monetary Policy Rules, pages 15-56 National Bureau of Economic Research, Inc.
    9. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters,in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246 National Bureau of Economic Research, Inc.
    11. Glenn Rudebusch & Lars E.O. Svensson, 1999. "Policy Rules for Inflation Targeting," NBER Chapters,in: Monetary Policy Rules, pages 203-262 National Bureau of Economic Research, Inc.
    12. Ball, Laurence, 1991. "The Genesis of Inflation and the Costs of Disinflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 439-452, August.
    13. Svensson, Lars E O, 1999. " Inflation Targeting: Some Extensions," Scandinavian Journal of Economics, Wiley Blackwell, vol. 101(3), pages 337-361, September.
    14. repec:fth:harver:1435 is not listed on IDEAS
    15. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-1311, July.
    16. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
    17. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, vol. 17(3), pages 247-252.
    18. Nelson, E., 1998. "Sluggish inflation and optimizing models of the business cycle," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 303-322, July.
    19. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
    20. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119.
    21. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters,in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
    22. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    23. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    24. Edmund Phelps, 1978. "Disinflation without recession: Adaptive guideposts and monetary policy," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 114(4), pages 783-809, December.
    25. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-984, November.
    26. Fuhrer, Jeff & Moore, George, 1992. "Monetary policy rules and the indicator properties of asset prices," Journal of Monetary Economics, Elsevier, vol. 29(2), pages 303-336, April.
    27. Mankiw, N Gregory, 1985. "Consumer Durables and the Real Interest Rate," The Review of Economics and Statistics, MIT Press, vol. 67(3), pages 353-362, August.
    28. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    29. Arturo Estrella, 1997. "Why do interest rates predict macro outcomes?: A unified theory of inflation, output, interest and policy," Research Paper 9717, Federal Reserve Bank of New York.
    30. Julio Rotemberg, 1987. "The New Keynesian Microfoundations," NBER Chapters,in: NBER Macroeconomics Annual 1987, Volume 2, pages 69-116 National Bureau of Economic Research, Inc.
    31. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
    32. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Econometric models;

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedbwp:98-5. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Catherine Spozio). General contact details of provider: http://edirc.repec.org/data/frbbous.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.