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Won’t Get Fooled Again – Or Will We? Monetary Policy, Model Uncertainty, and ‘Policy Model Complacency’

Listed author(s):
  • Mark Setterfield

    ()

    (Department of Economics, New School for Social Research)

The question addressed in this paper is: can monetary policy succeed in stabilizing the economy even when the policy model on which it is predicated is mis-specified? Using variants of the 3-equation New Consensus Macroeconomics model, it is shown that this question can be answered in the affirmative. The purpose of the paper is not to encourage indifference towards model uncertainty, however, but rather to warn against the perils of “policy model complacency”. This arises if the success of policy is misinterpreted as successful understanding of the workings of the economy, which makes the policy maker vulnerable to surprises: events with systematic origins in the “true” model of the economy that are not anticipated by the (mis-specified) policy model. To safeguard against this problem, policy makers should always entertain eclectic views of the workings of the economy – a task that is easily accomplished by paying more attention to “outside the mainstream” macroeconomic thinking that frequently makes predictions that are at odds with those of the dominant policy model.

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File URL: http://www.economicpolicyresearch.org/econ/2015/NSSR_WP_162015.pdf
File Function: First version, 2014
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Paper provided by New School for Social Research, Department of Economics in its series Working Papers with number 1516.

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Length: 23 pages
Date of creation: Jul 2015
Date of revision: Jan 2016
Handle: RePEc:new:wpaper:1516
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  1. N. Gregory Mankiw & Ricardo Reis & Justin Wolfers, 2004. "Disagreement about Inflation Expectations," NBER Chapters,in: NBER Macroeconomics Annual 2003, Volume 18, pages 209-270 National Bureau of Economic Research, Inc.
  2. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1295-1328.
  3. 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.
  4. Carlin Wendy & Soskice David, 2005. "The 3-Equation New Keynesian Model --- A Graphical Exposition," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-38, December.
  5. David Colander & Peter Howitt & Alan Kirman & Axel Leijonhufvud & Perry Mehrling, 2008. "Beyond DSGE Models: Toward an Empirically Based Macroeconomics," American Economic Review, American Economic Association, vol. 98(2), pages 236-240, May.
  6. Krugman, Paul, 2000. "How Complicated Does the Model Have to Be?," Oxford Review of Economic Policy, Oxford University Press, vol. 16(4), pages 33-42, Winter.
  7. Luca Gambetti & Jordi Galí, 2009. "On the Sources of the Great Moderation," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(1), pages 26-57, January.
  8. Gilberto Tadeu Lima & Mark Setterfield, 2008. "Inflation targeting and macroeconomic stability in a Post Keynesian economy," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 30(3), pages 435-461, April.
  9. Thomas I. Palley, 2002. "Economic contradictions coming home to roost? Does the U.S. economy face a long-term aggregate demand generation problem?," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 25(1), pages 9-32, January.
  10. Amitava Krishna Dutt, 2011. "Macroeconomic Theory After the Crisis," Review of Radical Political Economics, Union for Radical Political Economics, vol. 43(3), pages 310-316, September.
  11. Mark Setterfield & Shyam Gouri Suresh, 2014. "Aggregate structural macroeconomic analysis: a reconsideration and defence," Cambridge Journal of Economics, Oxford University Press, vol. 38(4), pages 797-815.
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