Policy Analysis with Econometric Models

Abstract

Policy Analysis withEconometric Models RECENTLY the rational expectations school has mounted an attack on the conventional use of simultaneous equations models for policy analysis. One might go further and say that among academic macroeconomists the conventional methods have not just been attacked, they have been discredited. The practice of using econometric models to project the likely effects of different policy choices, then choosing the best from among the projected outcomes, is widely believed to be unjustifiable or even the primary source of recent problems of combined high inflation and low economic activity. Instead, it is claimed, policy analysis should be formulated as choice among rules of behavior for the policy authorities and estimates should be made of the stochastic properties of the economy under each proposed rule to choose the best. This point of view has gained such wide acceptance in part because of its association with Lucas's theoretical demonstration that a Phillips curve could emerge in an economy in which such an association between inflation and real activity was not a usable menu for policy choice. Because users of conventional simultaneous equations models sometimes presented the Phillips curve as just such a menu, and because it became apparent in the 1970s that this menu was not helpful, an analysis that provided a cogent explanation for why the menu was chimerical had great appeal.As in most revolutions, the old regime toppled by the rational expectations revolution was corrupt and in some sense deserved its fate. However, as is often the case, the revolution itself has had its excesses, destroying or discarding much that was valuable in the name of utopian 0007-230318210002-0107 $1 .00/0 ?3 BrAookings Inistitlutioni 107 108 Brookings Papers on Economic Activity, 1:1982 ideology. This paper tries to assess where the revolution itself could use revision.I In this paper I argue that it is a mistake to think that decisions about policy can only be described, or even often be described, as choice among permanent rules of behavior for the policy authorities. A policy action is better portrayed as implementation of a fixed or slowly changing rule. I also argue that explicit identification of expectation-formation mechanisms is not necessary for policy analysis, concluding that the rational expectations critique of econometric policy analysis is a cautionary footnote to such analysis rather than a deep objection to its foundations. From this perspective, the conventional use of econometric models to aid in policy choice is neither self-contradictory nor meaningless. Applying Decision Theory to Economic PolicymakingFormal quantitative analysis of policy choice must begin with a model of the effects of policy. The model must describe the "outcome, " usually in the form of a probability distribution over future events in the economy, for each possible "setting of policy." To choose policy optimally, one evaluates the outcomes according to some objective function and chooses the best. Althou...

Efficiency of Foreign Exchange Markets: A Developing Country Perspective

“…In the variance decomposition analysis, the variance of the forecast error of a particular variable is partitioned into proportions attributable to innovations (or shocks) in each variable in the system including its own. If a variable can be optimally forecast from its own lags, then it will have all its forecast variance accounted for by its own disturbances (Sims, 1982).…”

Evaluating Monetary Policy Options

“…Also note that when the elements of the ε-path are small relative to the endogenous component, as should be the case with normal policymaking, agents are unlikely to benefit from reassessing the systematic policy rule. This is the empirical analog to the arguments by Sims (1982;1987) and Cooley-LeRoy-Ramon (1984) that with normal policymaking the Lucas critique is unlikely to be an issue.…”

“…For present purposes, we adopt a more intuitive terminology used by Sims (1982) and, more recently, Leeper and Sims (1994), who refer to "normal policymaking." In a recent paper, Leeper and Zha (2001) refer to "modest" policy interventions rather than "normal policymaking."…”

“…Such plots would only show the target paths described for each experiment. Sims (1982), in addition to discussing normal policymaking conceptually, also presented related empirical work. His empirical work assessed the plausibility of the political administration's forecasts of selected macro indicators by computing alternative combinations of shocks to the equations of the 6-variable VAR model he used that are consistent with the administration's forecasts.…”

“…The discussion of the proposed procedure is in the spirit of recent work by Leeper and Sims (1994) who, following earlier work by Sims (1982;1987), distinguish between normal policymaking and regime changes. For purposes of illustration, we employ a VAR model comprised of the same variables used by Christiano, Eichenbaum, and Evans (hereafter CEE) (1994;1996) and Bernanke and Mihov (hereafter BM) (1998).…”