Stanley Fischer: Reflections on macroeconomics then and now
Central bank: fed | Type: speech | Date: 2016-03-07

## Stanley Fischer: Reflections on macroeconomics then and nowSpeech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System,

at

the

'Policy

Challenges

in

an

Interconnected

World'

32nd

Annual

National Association for Business Economics Economic Policy Conference, Washington DC, 7 March 2016.*

*

*The chart can be found at the Board of Governors of Federal Reserve System's websiteI am grateful to David Lopez-Salido, Andrea Ajello, Elmar Mertens, Stacey Tevlin, and Bill English of the Federal Reserve

Board

for

their

assistance.

Views

expressed

are

mine,

and

are

not

necessarily

those

of

the

Federal Reserve Board or the Federal Open Market Committee.I am grateful to the National Association for Business Economics (NABE) for conferring the fourth annual NABE Paul A.

Volcker Lifetime Achievement Award for Economic Policy on me, thereby

allowing

me

the

honor

of

following

in

the

footsteps

of

Paul

Volcker,

Jean-Claude Trichet, and Alice Rivlin.

The honor of receiving the award is enhanced by its bearing the name of Paul Volcker, a model citizen and public servant, and a giant in every sense among central bankers.One thinks of many things on an occasion such as this one.

My mind goes back first to growing up in a very small town in Zambia, then Northern Rhodesia, and to the surprise and delight my parents would have felt at seeing me standing where I am now.

They would have been even more delighted that my girlfriend, Rhoda, whom I met when my parents moved to a bigger town in Zimbabwe, and I have been happily married for 50 years.

But that is not the story I will tell today.

Rather, I want to talk about our field, macroeconomics, and some of the lessons we have learned in the course of the last 55 years - and I say 55 years, because in 1961, at the end of my school years, on the advice of a friend, I read Keynes's General Theory for the first time.Did I understand it?

Certainly not.

Was I captivated by it?

Certainly, though 'captured' is a more appropriate word than 'captivated.' Does it remain relevant?

Certainly.

Just a week ago I took it off the bookshelf to read parts of chapter 23, 'Notes on Mercantilism, the Usury Laws, Stamped Money and Theories of Under-Consumption.' Today that chapter would be headed 'Protectionism, the Zero Lower Bound, and Secular Stagnation,' with the importance of usury laws having diminished since 1936.There is an old joke about our field - not the one about the one-handed economist, nor the one about 'assume you have a can opener,' nor the one that ends, 'If I were you, I wouldn't start from here.' Rather it's the one about the Ph.D. economist who returns to his university for his class's 50th reunion.

He asks if he can see the most recent Ph.D. generals exam.

After a while it is brought to him.

He reads it carefully, looking perplexed, and then says, 'But this is exactly the same as the exam I wrote over 50 years ago.' 'Ah yes,' says the professor. 'It is the same, but all the answers are different.'Is that really the case?

Not really, though it is true to some extent in the realm of policy.

To discuss

the

question

of

whether

the

answers

to

the

questions

of

how

to

deal

with macroeconomic policy problems have changed markedly over the past half-century or so, I will start by briefly sketching the structure of a basic macro model.

The building blocks of this model are similar to those used in many macro models, including FRB/US, the Fed staff's large-scale model, and a variety of DSGE (dynamic stochastic general equilibrium) models used at the Fed and other central banks and by academic researchers.The structure of the model starts with the standard textbook equation for aggregate demand for domestically produced goods, namely: 11. ;2.

Next is the wage-price block, which is based on a wage or price Phillips curve.

Okun's law is included to make the transition between output and employment;3.

Monetary policy is described by a money supply or interest rate rule;4.

The credit markets and financial intermediation are built off links between the policy interest rate and the rates of return on, and/or demand and supply functions for, other assets;5.

The

balance

of

payments

and

the

exchange

rate

enter

through

the

balance

of payments

identity,

namely

that

the

current

account

surplus

must

be

equal

to

the capital account deficit, corrected for official intervention;6.

Dynamics of stocks: There are dynamic equations for the capital stock, the stock of government debt, and the external debt.When I was an undergraduate at the London School of Economics (LSE) between 1962 and 1965, we learned the IS-LM model, which combined the aggregate demand equation (1) with the money market equilibrium condition set out in (3).

That was the basic understanding of the Keynesian model as crystallized by John Hicks, Franco Modigliani, and others, in which it was easy to add detail to the demand functions for private-sector consumption, C; for investment, I; for government spending, G; and for net exports.

The Keynesian emphasis on aggregate demand and its determinants is one of the basic innovations of the Keynesian revolution, and one that makes it far easier to understand and explain what factors are determining output and employment.Continuing

down

the

list,

on

price

and

wage

dynamics,

the

Phillips

curve

has

flattened somewhat since the 1950s and 1960s. 2

Further, the role of expectations of inflation in the Phillips curve has been developed far beyond what was understood when A.W.

Phillips - who was

a

New

Zealander,

an

LSE

faculty

member,

and

a

statistician

and

former

engineer

discovered what later became the Phillips curve.

The difference between the short- and longrun Phillips curves, which is now a staple of textbooks, was developed by Milton Friedman and Edmund

Phelps,

and

the

effect

of

making

expectations

rational

or

model

consistent

was emphasized by Robert Lucas, whose islands model provided an imperfect information reason for a nonvertical short-run Phillips curve.

In Okun's law, the Okun coefficient - the coefficient specifying how much a change in the unemployment rate affects output - appears to have declined over time.

So has the trend rate of productivity growth, which is a critical determinant of future levels of per capita income.- In

(3),

the

monetary

equilibrium

condition,

the

monetary

policy

decision

was

typically represented by the money stock at the LSE and perhaps also at the Massachusetts Institute of

Technology

(MIT)

after

the

Keynesian

revolution

(after

all,

'L'

represents

the

liquidity preference function and 'M' the supply of money); now the money supply rule is replaced by an interest-rate setting rule, for instance a reaction function of some form, or by a calculated 'optimal' policy based on a loss function.The development of the flexible inflation-targeting approach to monetary policy is one of the major

achievements

of

modern

macroeconomics.

Flexible

inflation

targeting

allows

for flexibility in the speed with which the monetary authority plans on returning to the target inflation rate, and is thereby close to the dual mandate that the law assigns to the Fed.1 A fuller description of the equations is contained in the appendix.2 See Blanchard (2016).A great deal of progress has been made in developing the credit and financial intermediation block.

As early as the 1960s, each of James Tobin, Milton Friedman, and Karl Brunner and Alan Meltzer wrote out models with more fully explicated financial sectors, based on demand functions for assets other than money.

Later the demand functions were often replaced by pricing equations derived from the capital asset pricing model.

Researchers at the Fed have been bold enough to add estimated term and risk premiums to the determination of the returns on some assets. 3

They have concluded, inter alia, that the arguments we used to make about how easy it would be to measure expected inflation if the government would introduce inflationindexed bonds failed to take into account that returns on bonds are affected by liquidity and risk

premiums.

This

means

that

one

of

the

major

benefits

that

were

expected

from

the introduction

of

inflation-indexed

bonds

(Treasury

Inflation-Protected

Securities,

generally called

TIPS),

namely

that

they

would

provide

a

quick

and

reliable

measure

of

inflation expectations, has not been borne out, and that we still have to struggle to get reasonable estimates of expected inflation.As students, we included NX, net exports, in the aggregate demand equation, but we did not generally solve for the exchange rate, possibly because the exchange rate was typically fixed.

Later, in 1976, Rudi Dornbusch inaugurated modern international macroeconomics - and here I'm quoting from a speech by Ken Rogoff - in his famous overshooting model. 4 As globalization of both goods and asset markets intensified over the next 40 years, the international aspects of

trade

in

goods

and

assets

occupied

an

increasingly

important

role

in

the

economies

of virtually all countries, not least the United States, and in macroeconomics.At

the

LSE,

we

took

a

course

on

the

British

economy

from

Frank

Paish,

whose

lectures consisted of a series of charts, accompanied by narrative from the professor.

He made a strong impression on me in a lecture in 1963, in which he said, 'You see, it (the balance of payments deficit)

goes

up

and

it

goes

down,

and

it

is

clear

that

we

are

moving

toward

a

balance

of payments crisis in 1964.' I waited and I watched, and the crisis appeared on schedule, as predicted.

But Paish also warned us that forecasting was difficult, and gave us the advice 'Never look back at your forecasts - you may lose your nerve.' I pass that wisdom on to those of you who need it.I

remember also my excitement at being told by a friend in a more senior class about the existence

of

econometric

models

of

the

entire

economy.

It

was

a

wonderful

moment.

I understood that economic policy would from then on be easy: All that was necessary was to feed

the

data

into

the

model

and

work

out

at

what

level

to

set

the

policy

parameters.

Unfortunately, it hasn't worked out that way.

On the use of econometric models, I think often of

something

Paul

Samuelson

once

said:

'I'd

rather

have

Bob

Solow's

views

than

the predictions of a model.

But I'd rather have Solow with a model than without one.'We learned a lot at the LSE.

But wonderful as it was to be in London, and to meet people from all over the world for the first time, and to be able to travel to Europe and even to the Soviet Union with a student group, and to ski for the first time in my life in Austria, it gradually became clear to me that the center of the academic economics profession was not in London or Oxford or Cambridge, but in the United States.There was then the delicate business of applying to graduate school.

There was a strong Chicago tendency among many of the lecturers at the LSE, but I wanted to go to MIT.

When asked why, I gave a simple answer: 'Samuelson and Solow.' Fortunately, I got into MIT and had the opportunity of getting to know Samuelson and Solow and other great professors.

And I

also met the many outstanding students who were there at the time, among them Robert Merton.

I took courses from Samuelson and Solow and other MIT stars, and I wrote my thesis3 See D'Amico, Kim, and Wei (2014).4 See Dornbusch (1976) and Rogoff (2001).BIS central bankers' speechesunder the guidance of Paul Samuelson and Frank Fisher.

From there, my first job was at the University of Chicago - and I understood that I was very lucky to have been able to learn from the great economists at both MIT and Chicago.

Among the many things I learned at Chicago was a Milton Friedman saying: 'Man may not be rational, but he's a great rationalizer,' which is a quote that often comes to mind when listening to stock market analysts.After four years at Chicago, I returned to the MIT Department of Economics, and thought that I

would never leave - even more so when MIT succeeded in persuading Rudi Dornbusch, whom I had met when he was a student at Chicago, to move to MIT - thus giving him too the benefit of having learned his economics at both Chicago and MIT, and giving MIT the pleasure and benefit of having added a superb economist and human being to the collection of such people already present.MIT was still heavily involved in developing growth theory at the time I was a Ph.D. student there, from 1966 to 1969.

We students were made aware of Kaldor's stylized facts about the process of growth, presented in his 1957 article 'A Model of Economic Growth.' They were:1.

The shares of national income received by labor and capital are roughly constant over long periods of time.2.

The rate of growth of the capital stock per worker is roughly constant over long periods of time.3.

The rate of growth of output per worker is roughly constant over long periods of time.4.

The capital/output ratio is roughly constant over long periods of time.5.

The rate of return on investment is roughly constant over long periods of time.6.

The real wage grows over time.Well, that was then, and many of the problems we face in our economy now relate to the changes in the stylized facts about the behavior of the economy: Every one of Kaldor's stylized facts is no longer true, and unfortunately the changes are mostly in a direction that complicates the formulation of economic policy. 5While the basic approach outlined so far remains valid, and can be used to address many macroeconomic policy issues, I would like briefly to take up several topics in more detail.

Some of them are issues that have remained central to the macroeconomic agenda over the past 50 years, some have to my regret fallen off the agenda, and others are new to the agenda.1.

Inflation and unemployment : Estimated Phillips curves appear to be flatter than they were estimated to be many years ago - in terms of the textbooks, Phillips curves appear to be closer to what used to be called the Keynesian case (flat Phillips curve) than to the classical case (vertical Phillips curve).

Since the U.S. economy is now below our 2 percent inflation target, and since unemployment is in the vicinity of full employment, it is sometimes argued that the link between unemployment and inflation must have been broken.

I don't believe that.

Rather the link has never been very strong, but it exists, and we may well at present be seeing the first stirrings of an increase in the inflation rate - something that we would like to happen.2.

Productivity and growth : The rate of productivity growth in the United States and in much of

the

world

has

fallen

dramatically

in

the

past

20

years.

The

table

shows calculated rates of annual productivity growth for the United States over three periods: 1952 to 1973; 1974 to 2007; and the most recent period, 2008 to 2015.

After having been 3 percent and 2.1 percent in the first two periods, the annual rate of productivity5 See Jones and Romer (2010).growth has fallen to 1.2 percent in the period since the start of the global financial crisis.The right guide to thinking in this case is given by a famous Herbert Stein line: 'The difference between a growth rate of 1 percent and 2 percent is 100 percent.' Why?

Productivity growth is a major determinant of long-term growth.

At a 1 percent growth rate, it takes income 70 years to double.

At a 2 percent growth rate, it takes 35 years to double.

That is to say, that with a growth rate of 1 percent per capita, it takes two generations for per capita income to double; at a 2 percent per capita growth rate, it takes one generation for per capita income to double.

That is a massive difference, one that

would

very

likely

have

severe

consequences

for

the

national

mood,

and possibly for economic policy.

That is to say, there are few issues more important for the

future

of

our

economy,

and

those

of

every

other

country,

than

the

rate

of productivity growth.At this stage, we simply do not know what will happen to productivity growth.

Robert Gordon of Northwestern University has just published an extremely interesting and pessimistic book that argues we will have to accept the fact that productivity will not grow in future at anything like the rates of the period before 1973.

Others look around and see impressive changes in technology and cannot believe that productivity growth will not move back closer to the higher levels of yesteryear. 6 A great deal of work is taking place to evaluate the data, but so far there is little evidence that data difficulties account for a significant part of the decline in productivity growth as calculated by the Bureau of Labor Statistics. 73.

The

ZLB

and

the

effectiveness

of

monetary

policy :

From

December

2008

to December 2015, the federal funds rate target set by the Fed was a range of 0 to ¼ percent,

a

range

of

rates

that

was

described

as

the

ZLB

(zero

lower

bound). 8 Between December 2008 and December 2014, the Fed engaged in QE - quantitative easing - through a variety of programs.

Empirical work done at the Fed and elsewhere suggests that QE worked in the sense that it reduced interest rates other than the federal funds rate, and particularly seems to have succeeded in driving down longerterm rates, which are the rates most relevant to spending decisions.Critics have argued that QE has gradually become less effective over the years, and should no longer be used.

It is extremely difficult to appraise the effectiveness of a program all of whose parameters have been announced at the beginning of the program.

But I regard it as significant with respect to the effectiveness of QE that the taper tantrum in 2013, apparently caused by a belief that the Fed was going to wind down its purchases sooner than expected, had a major effect on interest rates.More recently, critics have argued that QE, together with negative interest rates, is no longer effective in either Japan or in the euro zone.

That case has not yet been

empirically

established,

and

I

believe

that

central

banks

still

have

the capacity through QE and other measures to run expansionary monetary policies, even at the zero lower bound.4.

The monetary-fiscal policy mix : There was once a great deal of work on the optimal monetary-fiscal

policy

mix.

The

topic

was

interesting

and

the

analysis

persuasive.

Nonetheless the subject seems to be disappearing from the public dialogue; perhaps in ascendance is the notion that - except in extremis, as in 2009 - activist fiscal policy6 See, for instance, Mokyr, Vickers, and Ziebarth (2015).7 See Byrne, Fernald, and Reinsdorf (forthcoming).8 Inside the Fed, the range of 0 to 1/4 percent is generally called the ELB, the effective lower bound.should not be used at all.

Certainly, it is easier for a central bank to change its policies than for a Treasury or Finance Ministry to do so, but it remains a pity that the fiscal lever seems to have been disabled.5.

The

financial

sector :

Carmen

Reinhart

and

Ken

Rogoff's

book, This

Time

Is Different , must have been written largely before the start of the great financial crisis.

I find their evidence that a recession accompanied by a financial crisis is likely to be much more serious than

an

ordinary

recession

persuasive,

but

the

point

remains contentious.

Even

in the

case

of

the

Great

Recession,

it

is

possible

that

the

U.S. recession got a second wind when the euro-zone crisis worsened in 2011.

But no one should forget the immensity of the financial crisis that the U.S. economy and the world went through following the bankruptcy of Lehman Brothers - and no one should forget that such things could happen again.The subsequent tightening of the financial regulatory system under the Dodd-Frank Act

was

essential,

and

the

complaints

about

excessive

regulation

and

excessive demands for banks to hold capital betray at best a very short memory.

We, the official sector

and

particularly

the

regulatory

authorities,

do

have

an

obligation

to

try

to minimize the regulatory and other burdens placed on the private sector by the official sector - but we have a no less important obligation to try to prevent another financial crisis.

And

we

should

also

remember

that

the

shadow

banking

system

played

an important role in the propagation of the financial crisis, and endeavor to reduce the riskiness of that system.6.

The economy and the price of oil : For some time, at least since the United States became an oil importer, it has been believed that a low price of oil is good for the economy.

So when the price of oil began its descent below $100 a barrel, we kept looking for an oil-price-cut dividend.

But that dividend has been hard to discern in the macroeconomic data.

Part of the reason is that as a result of the rapid expansion of the production of oil from shale, total U.S. oil production had risen rapidly, and so a larger part of the economy was adversely affected by the decline in the price of oil.

Another part is that investment in the equipment and structures needed for shale oil production had become an important component of aggregate U.S. investment, and that component began a rapid decline.

For these reasons, although the United States has remained an oil importer, the decrease in the world price of oil had a mixed effect on U.S. gross domestic product.

There is reason to believe that when the price of oil stabilizes, and U.S. shale oil production reaches its new equilibrium, the overall effect of the decline in the price of oil will be seen to have had a positive effect on aggregate demand in the United States, since lower energy prices are providing a noticeable boost to the real incomes of households.7.

Secular

stagnation :

During

World

War

II

in

the

United

States,

many

economists feared that at the end of the war, the economy would return to high pre-war levels of unemployment - because with the end of the war, demobilization, and the massive reduction that would take place in the defense budget, there would not be enough demand to maintain full employment.Thus was born or renewed the concept of secular stagnation

-

the

view

that

the economy could find itself permanently in a situation of low demand, less than full employment, and low growth. 9

That is not what happened after World War II, and the9 I

am distinguishing in this section between secular stagnation as being caused by a deficiency of aggregate demand and another view, that output growth will be very slow in future because productivity growth will be very low.

The view that future productivity growth will be very low has already been discussed, with the conclusion that we do not have a good basis for predictions of its future level, and that we simply do not know whether future productivity growth will be extremely low or higher than it has been recently.

There is no shortage of viewsthought of secular stagnation was correspondingly laid aside, in part because of the growing confidence that intelligent economic policies - fiscal and monetary - could be relied on to help keep the economy at full employment with a reasonable growth rate.Recently, Larry Summers has forcefully restated the secular stagnation hypothesis, and argued that it accounts for the current slowness of economic growth in the United States

and

the

rest

of

the

industrialized

world.

The

theoretical

case

for

secular stagnation in the sense of a shortage of demand is tied to the question of the level of the interest rate that would be needed to generate a situation of full employment.

If the equilibrium interest rate is negative, or very small, the economy is likely to find itself growing slowly, and frequently encountering the zero lower bound on the interest rate.Research has shown a declining trend in estimates of the equilibrium interest rate.

That

finding

has

become

more

firmly

established

since

the

start

of

the

Great Recession

and

the

global

financial

crisis. 10 Moreover,

the

level

of

the

equilibrium interest rate seems likely to rise only gradually to a longer-run level that would still be quite low by historical standards.What factors determine the equilibrium interest rate?

Fundamentally, the balance of saving and investment demands.

Several trends have been cited as possible factors contributing

to

a

decline

in

the

long-run

equilibrium

real

rate.

One

likely

factor

is persistent

weakness

in

aggregate

demand.

Among the

many reasons for that,

as Larry Summers has noted, is that the amount of physical capital that the revolutionary information

technology

firms

with

high

stock

market

valuations

have

needed

is remarkably small.

The slowdown of productivity growth, which as already mentioned has been a prominent and deeply concerning feature of the past six years, is another important factor. 11 Others have pointed to demographic trends resulting in there being a larger share of the population in age cohorts with high saving rates. 12

Some have also pointed to high saving rates in many emerging market countries, coupled with a lack

of

suitable

domestic

investment

opportunities

in

those

countries,

as

putting downward

pressure

on

rates

in

advanced

economies

-

the

global

savings

glut hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago. 13Whatever the cause, other things being equal, a lower level of the long-run equilibrium real

rate

suggests

that

the

frequency

and

duration

of

future

episodes

in

which monetary policy is constrained by the ZLB will be higher than in the past.

Prior to the crisis,

some

research

suggested

that

such

episodes

were

likely

to

be

relatively infrequent and generally short lived. 14 The past several years certainly require us toon this issue among economists, but the views to some extent appear to depend on whether the economist making the prediction is an optimist or a pessimist.10

This research includes recent work by Johannsen and Mertens (2015) and Kiley (2015) that uses extensions of the original Laubach and Williams (2003) framework.

An international perspective on medium-to-long-run real interest rates is provided by U.S. Executive Office of the President (2015).

Reinhart and Rogoff (2009) and Hall (2014) discuss the long-lived effects of financial crises on economic performance.

See also Hamilton and others (2015).

I have, in addition, drawn on Fischer (forthcoming).11

It is also a major factor explaining the phenomenon of the economy's impressive performance on the jobs front during a period of historically slow growth.12

See, for instance, Gordon (2014, 2016).13

See Bernanke (2005).

See also the recent work by Caballero, Farhi, and Gourinchas (2008); and Mendoza, Quadrini, and Rios-Rull (2009).14

See, for instance, Reifschneider and Williams (2000), Blanchard and Simon (2001), and Stock and Watson (2003).reconsider that basic assumption.

Moreover, recent experience in the United States and other countries has taught us that conducting monetary policy at the effective lower bound is challenging. 15

And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful and effective, all central banks would prefer a situation with positive interest rates, restoring their ability to use the more traditional interest rate tool of monetary policy. 16The answer to the question 'Will the equilibrium interest rate remain at today's low levels permanently?' is also that we do not know.

Many of the factors that determine the equilibrium interest rate, particularly productivity growth, are extremely difficult to forecast.

At present, it looks likely that the equilibrium interest rate will remain low for the policy-relevant future, but there have in the past been both long swings and shortterm changes in what can be thought of as equilibrium real rates.Eventually, history will give us the answer.

But it is critical to emphasize that history's answer will

depend

also

on

future

policies,

monetary

and

other,

notably

including fiscal policy.

## Concluding remarksWell, are the answers all different than they were 50 years ago? No. The basic framework we learned a half-century ago remains extremely useful.

But also yes: Some of the answers are different because they were not on previous exams because the problems they deal with were not evident fifty years ago.

So the advice to potential policymakers is simple: Learn as much as you can, for most of it will come in useful at some stage of your career; but never forget that identifying what is happening in the economy is essential to your ability to do your job, and for that you need to keep your eyes, your ears, and your mind open, and with regard to your mouth - to use it with caution.Many thanks again for this award and this opportunity to speak with you.

## ReferencesBernanke, Ben S. (2005). 'The Global Saving Glut and the U.S. Current Account Deficit,' speech delivered at the Homer Jones Lecture, St. Louis, April 14.Blanchard, Olivier (2014). 'Where Danger Lurks: The Recent Financial Crisis Has Taught Us to Pay Attention to Dark Corners, Where the Economy Can Malfunction Badly,' Finance and Development, vol. 51 (September), pp. 28-31.-

-

-

-

(2016).

'The

U.S.

Phillips

Curve:

Back

to

the

60s?

(PDF)' Policy

Brief

16-1.

Washington: Peterson Institute for International Economics, January.Blanchard, Olivier, Eugenio Cerutti, and Lawrence Summers (2015). 'Inflation and Activity Two

Explorations

and

Their

Monetary

Policy

Implications

(PDF),'

IMF

Working

Paper WP/15/230.

Washington: International Monetary Fund, November.Blanchard,

Olivier,

and

John

Simon

(2001).

'The

Long

and

Large

Decline

in

U.S.

Output Volatility (PDF),' Brookings Papers on Economic Activity, 1, pp. 135-74.Brunner, Karl, and Allan H.

Meltzer (1972). 'Money, Debt, and Economic Activity,' Journal of Political Economy , vol. 80 (September-October), pp.951-77.15

For a discussion of various issues reviewed by the Federal Open Market Committee in late 2008 and 2009 regarding the complications of unconventional monetary policy at the ZLB, see the set of staff memos on the Board's16

See Williams (2013).Byrne, David M., John G.

Fernald, and Marshall Reinsdorf (forthcoming). 'Does the United States

Have

a

Productivity

Problem

or

a

Measurement

Problem?' Brookings

Papers

on Economic Activity .Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas (2008). 'An Equilibrium Model of 'Global Imbalances' and Low Interest Rates,' American Economic Review, vol. 98 (1), pp. 358-93.Daly,

Mary

C.,

John

G.

Fernald,

Òscar

Jordà,

and

Fernanda

Nechio

(2014).

'Output

and Unemployment Dynamics (PDF),' Working Paper Series 2013-32.

San Francisco: Federal Reserve Bank of San Francisco, November.-

-

-

-

(2014). 'Interpreting Deviations from Okun's Law,' FRBSF Economic Letter 2014-12.

San Francisco: Federal Reserve Bank of San Francisco.D'Amico,

Stefania,

Don

H.

Kim,

and

Min

Wei

(2014).

'Tips

from

TIPS:

The

Informational Content

of

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## AppendixThe following model includes a number of elements that play a central role in the analysis of economic fluctuations and in larger policy models as I have encountered them at the Federal Reserve and other institutions.An aggregate

demand relationship,

in

the

form

of

the

investment-saving

(or

IS)

curve, characterizes the negative dependence of economic activity on the real borrowing rate, , and the positive dependence on expected output, ; government spending, ; and net exports, , as a function of the exchange rate, , and foreign output, : — G ¥ WXThe Phillips curve describes a relationship between inflation and labor market slack.

Inflation responds negatively to the level of the unemployment gap, , and to changes in aggregate productivity, (including

shocks

to

commodity

prices).

Current

inflation

also

responds positively to expected future inflation, , and to the level of the borrowing rate and of the exchange rate, (cost - push shocks): x 5 se)Current issues regarding the role of expectations, the size of the slope, and the pass-through from

exchange

rate

movements

to

domestic

prices

and

wages

can

be

addressed

in

this context.

Recent discussions can be found in Blanchard's (2016) reference to the back-to-the1960s

thinking

about

the

Phillips

curve

and

in

Blanchard,

Cerutti,

and

Summers's

(2015) thoughts on hysteresis mechanisms underlying the inflation and unemployment dynamic.To connect cyclical fluctuations in the level of aggregate activity with changes in employment, Okun's law has been proved useful as an empirical description of the relationship between the output gap and the unemployment gap, (see Knotek (2007); and Daly, Fernald, Jordà, and Nechio (2013, 2014)): .To characterize monetary policy , it is nowadays useful to consider how the central bank affects the level of interest rates by setting the federal funds rate,

, in response to deviations of expected inflation from its target, (inflation gap), and percent deviations of output from its potential level, (output gap): . ¥To capture the role of credit and financial intermediation in the economy, consider a loan market equation , where the demand on the left-hand side depends negatively on the borrowing rate, , and the level of economic activity (higher income implies lower financing needs).

The supply of loans depends negatively on the level of interest rates,

, and positively on the level of

intermediation spreads, ,

and

income, (to

the

extent that

higher

aggregate income increases deposits and banks' capitalization and hence the supplies of intermediated funds).

This equation pins down the equilibrium level of the intermediation spread, : talThe borrowing rate, , is then equal to the sum of the risk-free rate set by the central bank, , and the spread, :This analysis is in the spirit of James Tobin's approach to monetary economics as was recently described by Solow (2004) and extended by Woodford (2010) to describe the role for financial intermediation shocks.

It also captures the work by B.

Friedman, B.

Bernanke, and A.

Blinderin thinking about the role of credit and credit spreads in the transmission of monetary policy impulses.Open economy aspects are captured by the following equations: The balance of payment is in equilibrium when net exports are compensated by capital flows of opposite sign.

Capital flows depend on the difference between the domestic interest rate and the foreign rate adjusted for depreciation:Furthermore, the uncovered interest rate parity equates the rate of return on domestic assets,

, to the rate of return on foreign assets,

, plus future expected changes in the exchange rate, , and a residual risk premium component, :For a detailed description of these relationships, see Dornbusch, Fischer, and Startz (2014); and Obstfeld and Rogoff (1996).