Comment on Computable General Equilibrium Models and Monetary Policy Advice
Author(s): Edward C. Prescott
Source: Journal of Money, Credit and Banking, Vol. 27, No. 4, Part 2: Liquidity, Monetary
Policy, and Financial Intermediation (Nov., 1995), pp. 1502-1505
Published by: Ohio State University Press
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Comment on COMPUTABLE
GENERALEQUILIBRIUM
MODELSANDMONETARY
POLICYADVICE,
by Edward C. Prescott
The authorsconstructan appliedgeneralequilibriummodel to be used in the monetarypolicy advice process. Applied generalequilibriummodels are the tools used to
evaluate alternativetax policies and to estimate the consequences of changes in
trade policies. However, to date they have not been used in the monetarypolicy
advice process.l A questionthen is why haven't appliedgeneralequilibriummodels
been used in the monetarypolicy selection process? Some historyis needed in order
to answer this question and to explain why the direction taken by the authors is
somewhatradicaland, I think, promising.
In the sixties and early seventies the basic Keynesianmacroeconometricmodel
was establishedtheory.Even the monetaristdetractors,when they were explicit, argued about the values of the coefficients of some of the equations. These models
with theirconsumptionfunction, investmentequation,money demandfunction, and
Phillips Curvefully integratedthe forecastingandpolicy analysisprocess. With this
framework,given the currentposition of the economy and the value of the policy
variables, the models predictedthe position of the economy next period. Thus the
Keynesian macroeconometricframeworkwas ideally suited to evaluate the consequences of alternativepolicy actions. Indeed, a macroeconometricmodel, along
with controltheory,could be used to determinethe optimalpolicy action today given an objective function specified by the political process.
Two problemsdeveloped with this practicefor macroeconometricforecastingand
policy evaluation. The firstwas that attemptsat providingtheoreticalunderpinnings
for these largely empiricallydeterminedmacroequationsdiscovereda fundamental
inconsistency between the theoreticaland macroeconometrictraditionin economics. Lucas (1976) in his famous critiqueof macroeconometricpolicy evaluationarticulatedand illustratedthis inconsistencyand arguedthatthe econometrictradition
was in need of majorreform. Essentially an implicationof theory is that the equations that define the law of motion of the economy are not invariantto the rule by
which policy is selected. Questions that the Fed is requiredby the 1946 Employment Act and 1978 Humphrey-HawkinsAct to answerarejust not well posed in the
language of economic theory.Indeed, we now know even if a policy rule is best (i)
1. Applied generalequilibriummodels have been used to evaluatethe welfare consequencesof different rates of inflation, that is, the welfare consequences of the inflationtax. They have not been used to
evaluate monetarypolicies designed to stabilize the economy.
EDWARD
C. PRESCOTT
is professor of economics at the Universityof Minnesotaand advisor, ResearchDepartment,FederalReserveBank of Minneapolis.
Journal of Money, Credit, and Banking, Vol. 27, No. 4 (November 1995, Part2)
Copyright 1995 by The FederalReserve Bank of Cleveland
COMMENTS :
1503
given the objective, (ii) given the assumedlaw of motion for the economy is the one
associatedwith thatpolicy rule, and (iii) given the incorrectassumptionthatthe law
of motion of the economy is invariantto the policy rule, that policy rule almost
surely is not optimal.
The second problemwas thatthe Keynesianmacroeconometricapproachfailed in
the seventies and failed in precisely the way that theory had predicted. Centralto
these models was a trade-offbetween inflationand unemployment.In the late sixties, economists confidentlypredictedthat sustained4 percentunemploymentand 4
percentinflationwas feasible. If society chose to toleratehigher inflation,a prediction of the macroeconometricmodels was that unemploymentwould be lower than
4 percent. In the seventies there were extended periods when the average inflation
rate was well above 4 percent while the average unemploymentrate was significantly in excess of 4 percent. This is counter to the predictions of the macroeconometricmodels. This was a spectacularfailurewhich was acknowledgedin the
Federal Reserve Bank of Boston's 1978 conference A$terthe Phillips Curve: Persistence of High Unemployment.
With the failure of the macroeconometricmodels, atheoreticalmethods, in particular the vector autoregression(VAR) methods of Sims (1980), came to prominence in macroeconomicforecasting. These techniquesprovedinvaluablein testing
the implicationsof Lucas' (1972) monetarysurprisetheoryof business cycle fluctuations as well as being useful in making unconditionalforecasts, but VAR methods
provided virtuallyno guidance to policy selection.
At that time theory was not much help in providing guidance in the monetary
policy advice process. About all thattheorysaid was to follow policy rules thathave
been used in the past and that resultedin the economy's operatingreasonablywell.
Policymakers do not like to be told such things and legislated that the macroeconometricmodels with their Phillips Curvebe used to do what theorysays cannot
be done. There is still the Board of Governors'model with a discreditedPhillips
Curve at its center.
To summarize, with the demise of the Keynesian macroeconometricmodels,
economists were faced with a problem of what to do when it came to macroeconomic forecastingand policy advising. Underthe leadershipof Sims, the vector
autoregressionmethods moved to prominence. These models forecastedas well as
the macroeconometricmodels, but how to use them for makingpolicy advice, given
the Lucas critique, is a problem with no solution.
Greatprogresshas been made in the developmentanduse of appliedgeneralequilibrium models in public finance, trade, and business cycle research. Central to
these aggregatemodels is the neoclassicalproductionfunction, or a multisectorgeneralizationof it.2 Not surprisinglythis constructis used in the Altig, Carlstrom,and
Lansing paper. In a simple parsimonious way the aggregate productionfunction
2. Very recently applied general equilibriummodels that begin at the plant level and explicitly carry
out the aggregations are being used. Examples are Cooley, Hansen, and Prescott (1995), Fitzgerald
(1995) and Veracierto(1995). To addressmany issues, such as those involving variationsin capital utilization rates, the movement of workersbetween plants, and the welfare consequences of constraintson
the length of the work week, requirestheorizingat the plant level.
1504 : MONEY, CREDIT,AND BANKING
summarizespeople's ability to substitutebetween goods where the key goods are
today's and futureconsumptionsand labors. In orderto summarizepeople's willingness to substitutebetween these goods, the authorsuse the preferenceorderwhich
throughsuccessful use has become the standardone for aggregateanalysis. On the
real side the model is quite standard.
More problematicis the monetaryside of the model. Here the authorsuse what I
we as the currentlyleading constructfor a theory of money, namely, the limited
participationstructurewith firmsborrowingfrom financialintermediariesto finance
their wage bill and households facing a cash-in-advanceconstraint.The reasons I
think the theory underlyingthe monetaryside model is not at the same level as the
theory underlyingthe real side are as follows. One reason is the counterfactualimplication of the theory that the averagereal returnon governmentdebt will almost
equal the averagereturnon capital. In fact, this is not the case. Over the last hundred years the averagereal returnon capitalwas close to 5 percentwhile the average
real interest rate on short-termgovernmentdebt was only 1 percent. It is unfairto
criticize a model just because it is false. All abstractionsare by definitionfalse and
do not match reality on many dimensions. It is far from clear whetheror not this
particulardiscrepancy should lessen our confidence in the guidance the authors'
model provides in the monetarypolicy advice process. Given that the authorsabstractedfrom the costs of financial intermediation,the failure to match on this dimension may be a plus ratherthan a minus.
A second reason is that the model does not match reality in the behaviorof the
differences in the real returnon capital and the federal funds returnover time. In
fact, five-year moving averagesof these differencesvary from as low as 3 percentto
as high as 7 percent. With the monetarytheoreticalframeworkused by the authorsit
is the surprisesthat give rise to this difference, and only extremelyunlikely events
could give rise to such large variationsin five-yearmoving averages. This counterfactual observationdiminishes my confidence in the use of this structurefor shortterm monetary advice. Successful use of the theory, however, would change my
views.
There are two sources of uncertaintyin the authors'model. One is the shock to
the productiontechnology and the other is the shock to the interest rate pegging
equation. The shock to the technology of productionis standard,the shock to the
interestrate pegging equationis not. If the Fed has limited abilities to peg the interest rate, and is only able to peg the one-period-aheadexpected value, then this
second shock makes sense. It seems to me thatpegging of the federalfunds ratecan
be done on an almost weekly basis, and this permits the quarterlyrate to be set
virtuallyat the desiredlevel. This implies a negligible shock in the interestratepegging equation. Anotherpossibility that would lead to following such a rule is that
randomnessin the interestrate pegging rule is perceived to be optimal. There are
cases for which randomnessin policy is best.
One problem that the authorsdiscuss is that there may be an infinite numberof
stationarymoney growth rules that will supporta given interestrate target. In their
analysis they restrictattentionto the money growth rule that is both stationaryand
not dependent on "sunspot"variables. I compliment the authors for being open
COMMENTS :
1505
aboutthis possible multiplicityproblem. More likely thannot, for theirmodel there
are not sunspot equilibria.The reason for this statementis that talentedeconomists
have been searchingfor economies thathave multipleequilibriaand that are consistent with the data. Benhabib and Farmer(1994), for example, find that there are
multiple equilibriafor the class of economies that they consideronly if the increasing returnsto scale are ridiculouslylarge. Perhapsthis multiplicityof equilibriawill
prove to be a big problem, but to date it has been more a theoreticalpossibility than
a practical problem. This is not to advocate not worrying about the possibility of
multiple equilibria. Rather it is to advocate going ahead with the applied general
equilibriumanalysis and worryingaboutthe multiplicityproblemif it arises.
In summaryI commend the authorsfor bringingtheory into the forecastingand
policy advice process. That their extremely simple structureforecastedas well as it
did, being as good as the atheoreticalvector autoregressionmethodsand the Board
of Governors'large-scale macroeconometricmodel, is surprising.The authorstake
a first step in developing an applied general equilibriummodel that can be used in
the monetarypolicy advice process. However, there are limits to what successful
theory can do. These models cannot provide forecasts of what will happen under
alternativepolicy scenarios. They can provide assessmentof the currentstate of the
economy and, given the policy rule, better determinethat action called for by the
rules being followed. For example, the rule may specify differentreactions to increases in the real interestratethatare due to shocks to the technologyof production
and those due to shocks to the technology of exchange. Currently,theory is providing guidance as to which variables to focus on on the real side, namely, hours
workedper adultand total factorproductivityas well as the consumptionand investment shares. Theoryprovides less guidanceon the monetaryside. Thatthe authors'
simple model forecastedas well as it did is very promisingfor theory.
LITERATURECITED
Benhabib,Jess, and Roger E.A. Farmer."Indeterminacyand IncreasingReturns."Journalof
Economic Theory63 (1994), 19-41.
Cooley, Thomas F., GaryD. Hansen, and EdwardC. Prescott."EquilibriumBusiness Cycles
with Idle Resources and VariableCapacity Utilization." Journal of Economic Theory 6
(August 1995), 36-49.
Fitzgerald, TerryJ. "TeamProductionin GeneralEquilibrium:Theory and an Application."
Ph.D. thesis, University of Minnesota, 1995.
Lucas, RobertE., Jr. "Expectationsand the Neutralityof Money."Journalof Economic Theog 4 (April 1972), 103-24.
Lucas, Robert E., Jr. "EconometricPolicy Evaluation:A Critique."In The Phillips Curve
and Labor Markets, K. Brunnerand A. Meltzer,eds., Carnegie-RochesterConferenceSeries on Public Policy, 1 (1976), 19-46.
Sims, ChristopherA. "Macroeconomicsand Reality."Econometrica48 (January1980), 148.
Veracierto,Marcelo L. "Essays on Job Creatsonand Job Destruction."Ph.D. thesis, University of Minnesota, 1995.