The thinking of a ”Great Moderation” economist

Imagine you are ”born” as a macroeconomists in the US or Europe around 1990. You are told that you are not allowed to study history and all you your thinking should be based on (apparent) correlations you observe from now on and going forward. What would you then think of the world?

First, you all you would see swings in economic activity and unemployment as basically being a result of swings in inventories and moderate supply shocks when oil prices drop or increase due to “geo-political” uncertainty in the Middle East. What is basically “white noise” in economic activity in a longer perspective (going back for example a 100 years) you will perceive as business cycles.

Second, inflation is anchored around 2% and you know that inflation normally tend to move back to this rate, but you really don’t care why that is the case. You will tell people that “globalisation” is the reason inflation remains low. But you also think that when inflation diverges from the 2% rate it is because geo-political uncertainty pushes oil prices up. Sometimes you will also refer to a rudimentary version of the Phillips curve where inflationary pressures increase when GDP growth is above what you define as trend-growth around 2-3%. But basically you don’t spend much time on the inflation process and even though you know that central banks target inflation you don’t really think of inflation as a monetary phenomenon.

Third, monetary policy is a focal point when you talk about economic policy. You will say things like “the Federal Reserve is increase interest rates because growth is strong”. For you think monetary policy is about controlling the level of interest rates. You never look at money supply numbers and have no real idea about how monetary policy is conduct (and you really don’t see why you should care). Central banks just cut or hike interest rates and central bankers have the same model as you so they move interest rates up or down according to a Taylor rule. And if somebody would to ask you about the “monetary transmission mechanism” you would have no clue about what they are talking about. But then you would explain that the central bank sets interest rates thereby control “the price of money” (this is here the Market Monetarist will be screaming!) and that this impact the investment and private consumption.

Forth, your world is basically “stationary” – GDP growth moves up and down 1-2%-point relative to trend growth of 2%. The same with inflation – inflation would more or less move around 2% +/- 1%-point. Given this and the Taylor rule it follows that interest rates will be moving up and down around what you will call the natural interest rate (you don’t know anything about Wicksell – and you don’t care what determine the natural interest rate). So sometimes interest rates moves up to 5-6% and sometime down to 2-3%.

What you off course does not realise is that what you are doing has nothing to do with macroeconomics. You are basically just observing “white noise” and trying to make sense of it and your economic analysis is basically empirical observations. You never heard of the Lucas critique so you don’t realise that observed empirical regularities is strictly dependent on what monetary policy regime you are in and you don’t realise that nominal GDP (NGDP) is growing closely around a 5% growth path and that mean that “macroeconomics” basically has disappeared. Everything is now really just about microeconomics.

And then disaster hits you right in the face! Nominal GDP collapses (you think it is a financial crisis). You are desperate because now the world is no longer “stationary”. All you models are not working anymore. What is happening? You are starting to make theories as you go alone (most of them without any foundation in logic analysis – crackpots have a field day). Now interest rates hit 0%. Your Taylor rule is telling you that central banks should cut interest rates to -7%. They can’t do that so that mean we are all doomed.

Then enters the Market Monetarists…they tell you that interest rates is not the price of money, that we are not doomed and central bank can ease monetary policy even with interest rates at zero if we just implement NGDP level targeting. You look at them and shake your head. They must be crazy. Haven’t they studied history?? They indeed have, but their history book started in 1929 and not in 1990.

Leave a comment


  1. Excelent parody, Lars.
    But I disagree just in a point: It was really a financial crisis. All that imply very strong moves in assets prices… dificult to stop. By that I mean that perhaps a very loose MP could get stop it, but not inmediatly.
    I think that financial crisis exist, not all is money.

  2. Benjamin Cole

     /  December 7, 2011

    Perhaps we in the Market Monetarism movement should lay out a course of action…

    Such as (in the USA), the Fed buying $100 billion a month in bonds or assets not to a dollar amount target (such as $600 billion), but to a NGDP target, and wiping out IOR…and for the ECB a similar action.

    Perhaps if we lay out some concrete steps and targets….talking point, and get the argument into our court again…we may be losing traction here….

  3. Well, rereading this post and the Arash´s one, I find that this is a good example on waht I said before: the financial crisis exists, and it we can not subsume it in an general monetary problem.
    What I like of Arash´s position is that he recognises the existence of a financial problem -and a big one. sure, the source of its solution is central bank and an expansion of money, but not in a generalised manner.

  4. Luis, I surely do agree that there was a financial crisis and that it is an important part of the crisis. In the case of Europe we can not solve everything by just introducing NGDP targeting (even though it would be very helpful indeed). What I meant to argue is that many economists that “grew up” in the Great Moderation really does not understand the importance of a stable growth rate in NGDP and had NGDP been kept stable by monetary policy then we would not have been in this crisis.

    Benjamin, I am not sure that you are right. Market Monetarists are arguing that expectations are extremely important in the transmission mechanism. Therefore we can not say that the Fed should pring xzy dollar to get us out of the crisis. Instead we should state as we do that the Fed can pull us out of this crisis by announcing a clear NGDP targeting and announce that it would print as much money as need to get to this target.

  5. Benjamin Cole

     /  December 8, 2011


    I see your point, but I am suggesting that the Fed announce it targets, and that it would buy $100 billion in assets a month until it hit its targets.

    The concrete nature of the QE would give the markets confidence and a talking point. Wipe out IOR too.

    The more-abstract nature of “we will hit out announced targets” sounds a little too “pie-in-the-sky.”

    • Ben, I suppose you think that what Japan just did was “pie-in-the-sky”, too, then?

      A central bank can hit any (nominal) target it clearly announces, and the markets don’t need to be convinced of that so long as the central bankers themselves are convinved.

  6. Lars, i agree, except for
    “had NGDP been kept stable by monetary policy then we would not have been in this crisis.”
    I would like it, but I think Greenspan was right when he said,
    Too much stability too much time, at the end leads to an excess of confidence.
    I mean that I´m not sure that had NGDP been stable, there would be not house bubble.
    For instance, was the dot com bubble by a excesive NGDP growth?
    The answer is important, because the Monetary policy must (or not) be coupled with a financial stability policy. If I´ve undestood well Svensson, Monetary policy is not sufficient to cover both targets, real and financial stability markets.
    but if all concern is only monetary… I don´t believe it.

  1. The biggest cost of nominal stability is ignorance « The Market Monetarist
  2. Daniel Lin is teaching macro! Lets introduce his students to the IS/LM+ model « The Market Monetarist

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: