Lambda
Speech given by
Mark Carney, Governor of the Bank of England
London School of Economics
Monday 16 January 2017
I am grateful to Ben Nelson and Iain de Weymarn for their assistance in preparing these remarks, and
to Alex Haberis, Clare Macallan, Michael Mcleay, Kate Reinhold, and Matt Waldron for background
research and analysis.
Good evening. It is a pleasure to be at the LSE and an honour to share the podium with Amartya Sen.
Professor Sen is rightly recognised for his many contributions, not least to welfare economics and social
choice theory. He has posed, and in many cases answered, some of the most fundamental questions facing
economists. For example, given the diversity of people's preferences, is it possible to arrive at coherent
aggregative judgements about how society is arranged? If there are as many preferences as there are
people, is reasonable social choice possible at all? And how do we value public goods?
- -
His work underscores the value of empirics informational broadening to help make the interpersonal
comparisons necessary to understand, and act upon, the force of public concerns about poverty, inequality,
even tyranny. And his insights have been applied to the most pressing economic and ethical questions,
such as the prevention of famines.
His insights are also relevant to social choices about macroeconomic stabilisation, including inflation control,
and what society is prepared to do to achieve it.
What level of inflation does society wish to achieve? How aggressively should inflation stabilisation be
pursued when doing so imposes costs in terms of lost output and higher unemployment?
Low, stable and predictable inflation is a public good. It is not merely that rising prices mean households
have to shop around or businesses have to update their prices periodically. High inflation hurts those,
particularly the worst off in society, who don't hold equities or property
as well as those whose incomes are
fixed in nominal terms. It distorts price signals, inhibits investment, and can ultimately damage the productive
potential of the economy.
Equally, deflation can imperil growth and employment. In a highly indebted economy, deflation raises real
interest rates, increases debt burdens, lowers wages, and reduces growth. In the extreme, these can morph
into debt deflation, causing very high and persistent unemployment and financial collapse.
A little inflation 'greases the
The happy medium is low, stable, predictable inflation over the medium term.
wheels' of the economy, for example by helping real wages adjust more smoothly.1
Moreover, a positive
inflation rate gives monetary policy space to deliver better outcomes for jobs and growth when shocks hit,
without the distortionary costs of high and volatile inflation.2
Recognising the social value of inflation control is one thing, delivering it is quite another.
-
In the past, many societies could not. This is because the instrument that affects inflation most powerfully
-
monetary policy also affects output and employment, at least in the short run. That influence tempted
1
See Tobin (1972), "Inflation and unemployment", American Economic Review, 62.
2
Inflation can have large redistributive effects. Volatile inflation arbitrarily re-distributes wealth across borrowers and savers. And most
recently, there has been a debate about how the stance of monetary policy has affected the distribution of wealth and income. In a
series of recent analysis and speeches, members of the MPC have shown that, while distribution is not an objective of monetary policy,
the evidence strongly suggests that policy since the crisis has been associated with better outcomes.
authorities to promise low inflation in the future, but then to renege in order to boost activity. Electoral cycles
reinforced this predisposition.3 Firms and households began to anticipate these incentives, however, and
eventually pre-empt them. The economy ended up in a worse equilibrium with higher inflation and
unemployment.4 Such time-inconsistent policies contributed to excessive inflation and higher structural
unemployment in the UK during the 1970s and 1980s (when inflation averaged 9.5% and unemployment
over 7.5%).
In light of similar experiences, many societies came to recognise that macro outcomes can be improved by
having society first choose the preferred rate of inflation and then delegate operational responsibility to the
By "tying the hands" of
monetary authority to take the necessary monetary actions to achieve that objective.5
authorities, time inconsistency is resolved and better outcomes for both inflation and unemployment become
possible.
Inflation targeting, as practised in the UK, represents the most comprehensive adoption of these insights. By
delegating monetary policy to an operationally independent central bank, inflation control becomes a more
technical, 'engineering' problem, as described in Professor Sen's work on ethics and economics.6 The
- -
committee responsible is given a clear remit with a lexicographic preference for inflation control and is
charged to do what is necessary to achieve the inflation target over the policy horizon. For example, the
Monetary Policy Committee (MPC) of the Bank of England must deliver price stability over the medium term,
as defined by 2% CPI inflation. The inflation target is symmetric (meaning we care as much about returning
inflation to target from below as from above), and it applies at all times.
To be clear, although the method by which the Bank of England achieves the inflation target may be a
technical exercise, the UK's monetary policy framework is grounded in society's choice of the desired end.
These ethical determinations are encoded in the monetary policy remit, from which the MPC takes its orders
and against which it is accountable. Society chooses the ends, and, within pre-set boundaries, the MPC
determines the means to achieve them.
Yet even in this framework monetary policymaking will at times involve striking short-term trade-offs between
stabilising inflation and supporting growth and employment. In other words, the monetary policy problem
ex
cannot be fully contracted ante. But to re-emphasise, decisions about the precise trade-off that the MPC
remit. And they are
pursues are subject to the limits provided by its statutory objectives and the Chancellor's
disciplined by the transparency and accountability mechanisms including Inflation Reports, the minutes and
transcripts of its meetings, the Parliamentary testimonies of its members, the open letter process triggered if
3
Nordhaus, W D (1975), "The political business cycle", Review of
Economic Studies.
4
See, inter alia, Kydland, F and Prescott, E, (1977), "Rules rather than discretion: the inconsistency of optimal plans",
Journal of
Political Economy, 85(3), 473-492; Barro, R, and Gordon, D B, (1983). "A Positive Theory of Monetary Policy in a Natural-Rate Model".
Journal of Political Economy. 91 (4): 589-610.
5
See Rogoff, K (1985), "The optimal degree of commitment to an intermediate monetary target", Quarterly Journal of Economics,
November, pages 1,169-90.
6
The 'engineering' view is primarily concerned "with logistic issues rather than with ultimate ends", including their ethical characteristics.
"The ends are taken ... as given, and the object of the exercise is to find the appropriate means to serve them". See Sen, A K
(1987),
On ethics and economics, Blackwell.
the inflation target is missed by more than one percentage point, and discussions and debates in public fora
such as this one.
The balance of my remarks this evening will concentrate on the experience with such trade-offs, which have
become more common of late for two reasons. First, since the global financial crisis, the UK economy has
been subject to a series of major supply shocks, which, for reasons that I will explain, create a tension
between short-term inflation and output stabilisation. And second, there has been a renewed recognition
that, in extreme circumstances, the monetary authority may have to take into account financial stability
considerations in setting monetary policy with potential consequences for the short-term path of inflation
control.
These are big decisions, decisions subject to considerable uncertainty, and decisions which entail potentially
large welfare costs, arising from high unemployment and unevenly distributed costs of inflation. They
with society's preferences
deserve scrutiny to ensure that they are consistent as expressed in statute and
remit.
1. Monetary policy remit
For most of the Bank's history, an assessment of whether it was acting in a way consistent with society's
view of the public good could not be made.
As former Governor Eddie George remarked, during the half century that followed its nationalisation in 1946
"the Bank operated under legislation which, remarkably, did not attempt to define our objectives or functions."
They were, instead, "assumed to carry over from [the Bank's] earlier long history."7 In that regard, the Bank's
'constitution' resembled that of the United Kingdom more broadly, comprising a rich history of law, principle
and convention.
All changed with the passing of the Bank of England Act in 1998, which made specific "provision about the
constitution, regulation, financial arrangements and functions of the Bank." The Act clarified the Bank's
responsibilities and granted independence to the Bank for the operation of monetary policy. In delegating
authority to an independent body, the MPC, in this way, the Act ensured the Bank would operate under
'constrained' rather than 'unfettered' discretion.8 It would be accountable to Parliament for operating the
instruments of monetary policy to achieve the objectives of monetary policy, as determined by the
Government.
The operational independence of the Bank of England is an example of power flowing from the people via
Parliament within carefully circumscribed limits. Independence in turn demands accountability for the Bank to
command the legitimacy necessary to fulfil its mission. By publishing its analysis, giving testimony, and
7
George, E. (2000), "Central bank independence", speech at the SEANZA Governors' Symposium, 26 August 2000.
8
See, for example, King, M. (2000), "Monetary policy: theory in practice", 7th January 2000. King attributes the 'constrained' versus
'unfettered' distinction originally to Ben Bernanke and Frederick Mishkin.
delivering speeches, the Bank explains how it is exercising its powers to achieve its clearly defined policy
remits.
Today, the MPC's
monetary policy remit requires it to achieve price stability, defined by the Government to
mean 12-month CPI inflation of 2%. The remit recognises that inflation may deviate temporarily from the
target on account of shocks, however. Since 2013, the remit has explicitly recognised that in these
circumstances, bringing inflation back to target too rapidly could cause volatility in output and employment
that is undesirable. The remit requires the MPC to consider, balance and explain such short-run monetary
policy trade-offs.
in exceptional circumstances, "shocks to the economy may be particularly large or the effects of
Specifically,
shocks may persist over an extended period or both". When this is the case, the challenge facing the MPC
the remits directs that "[i]n forming and communicating its judgements, the
can be more significant, and
inherent in setting monetary policy", including,
Committee should promote understanding of the trade-offs
importantly "the horizon over which the Committee judges it is appropriate to return inflation to the target".
2. Achieving price stability
A simple framework for thinking about how to manage the monetary policy trade-off is shown in Figure 1.
The red line in the figure illustrates a policymaker's preferred
trade-off: mapping the size of the shortfall of
- -
output below potential the output gap that the policymaker is prepared to tolerate for a given overshoot of
inflation from target, and vice versa. The flatter the line the less the weight the policymaker places on output
stabilisation and the more they are willing to tolerate large output gaps in order to eliminate small overshoots
in inflation.
Figure 1: A stylised depiction of the monetary The blue line in the figure is the Phillips curve, which
policy trade-off
summarises the structure of the economy and, in
particular, how changes in demand, via the output
The economy's equilibrium is at
gap, affect inflation.9
the intersection of these two lines.
In the case of an inflationary shock that induces a
trade-off, the Phillips curve shifts up, as shown in the
figure. Monetary policy needs to tighten to lower
pressure on resources and reduce inflationary
pressures, such that the economy ends up on the
9
Originally formulated by Phillips (1958), albeit as a relationship between wage growth and unemployment. See: Phillips, A. W. (1958).
"The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957". Economica,
25 (100): 283-299.
red line, consistent with the policymaker's preferences (as shown by
the dotted arrows in the figure). The
slope of the Phillips curve is crucial in determining in the size of the fall in output needed to reduce inflation to
-
an acceptable level the sacrifice ratio.
Figure 2: Stylised policy responses Frequently, the economy experiences shocks that
drive inflation and output in the same direction.
These shocks to aggregate demand can include
variations in government consumption, households'
desire to consume, or business' desire to invest.
Increases in demand put pressure on the use of
resources, causing prices to rise. Because monetary
policy can also influence demand it can lean against
such shocks. If successful, it can stabilise inflation.
In this case, no output-inflation trade-off arises. This
is the so-called "divine coincidence".10
In Figure 2, negative demand shocks would create a tendency for inflation and the output gap to move into
the south-west quadrant. Similarly, for positive demand shocks, inflation and output gap would move to the
north-east. Because in these cases, there is no trade-off between stabilising inflation and the output gap, it is
relatively straightforward for monetary policy to keep inflation and the output gap close to the origin.
Chart 1: For much of the great moderation In practice, data in these quadrants reflect lags in the
period, data were consistent with
transmission of monetary policy and other
predominance of demand shocks...
Inflation uncertainties: it takes time for monetary policy to
3.5
(%)
Great moderation
affect output, and for output in turn to affect inflation.
3
But if monetary policy has been effective, these
deviations would not be expected to be either large or
2.5
persistent. This state of affairs characterised much of
the "Great Moderation" in the United Kingdom, from
Output gap (%)
2
-1 0 1
1993 to 2007 (Chart 1), which was effectively a
period of demand management.11
1.5
Things are different when shocks drive inflation up or
1
down independently of demand. Exogenous changes
0.5
in firms' pricing power are one -
example so-called
cost-push shocks. Shocks to the exchange rate, the
0
economy's supply capacity,
or commodity prices also
Source: Bank calculations.
10
See Blanchard, O., and J. Galí (2007). "Real Wage Rigidities and the New Keynesian Model". Journal of Money, Credit, and Banking,
39(1), pp. 35-65.
11
See Broadbent, B (2013), "Conditional guidance as a response to supply uncertainty", speech at the London Business School.
... whereas after the financial crisis, Because monetary policy's
Chart 2: have this flavour.12
the economy experienced a challenging
influence on inflation is predominantly an indirect one,
monetary policy trade-off
via demand, in such circumstances inflation can only
Financial crisis and after
Inflation
6 be controlled by delivering an opposing movement in
(%)
aggregate spending. If something pushes up on
5
inflation directly, monetary policy can only bring
inflation back down by causing a reduction in
4
spending via higher interest rates. The speed with
3
which this adjustment is delivered is determined by
the monetary policy maker guided by their remit.
2
-6 -5 -4 -3 -2 -1 0 1
Output gap (%)
1
Such circumstances have characterised the period in
the UK since the global financial crisis (Chart 2),
0
which entailed a large adjustment to the supply side
-1 of the economy, meaning a lower exchange rate,
lower growth, and higher inflation.
Source: Bank calculations.
Chart 4: ... as has the euro area
Chart 3: US has continued to experience
predominantly demand shocks, not trade-off
shocks, since the global financial crisis...
Great moderation
Inflation (%) Inflation (%)
Great moderation
6
4.5
Financial crisis and after
Financial crisis and after
4
5
3.5
4
3
2.5
3
8
2
2 -4 -2 0 2 4
1.5
-8 -6 -4 -2 0 2 4
Output gap
(%)
1
Output gap 1
(%)
0.5
0
0
-1
-0.5
-1
-2
Source: Bureau of Economic Analysis, CBO and Bank Source: Eurostat, IMF and Bank calculations. The measure of
calculations. The measure of inflation is the four-quarter inflation is the four-quarter change in the harmonised index of
consumer prices (HICP). The output gap is the IMF's estimate
change in the personal consumption expenditures (PCE)
deflator. The output gap is calculated using the CBO estimate from the October 2016 WEO at an annual frequency,
of potential output from its August 2016 Update to the Budget interpolated to create a quarterly series.
and Economic Outlook.
12
Exchange rate shocks also have demand effects including via net trade. For example, a higher exchange rate lowers imported price
pressures, reducing inflation directly. It also makes domestic goods less attractive on world markets, lowering the contribution of net
trade to demand, which has second-round effects on inflation via the reduced demand of exporters for labour. At the same time, real
household income rises with a higher exchange rate, providing some countervailing support to demand and domestically-generated
inflation.
In contrast, the US and the euro area have seldom faced a trade-off between output and inflation
stabilisation, even since the global financial crisis (Charts 3 and 4).
is in
A simple way to represent more formally how the policymaker optimises the trade-off "linear-quadratic"
-
form a set of linear constraints describing the behaviour of the economy, and quadratic preferences that
penalise deviations of inflation from its target and output from its potential. The relative weight the
κ - or 'lambda'.
policymaker places on output stabilisation, relative to inflation stabilisation, is often denoted
The policymaker's "loss function"
in any particular time period is:
∗)2
≡ - π∗)2 + -
Lorrt (πt κ(xt xt
∗ ∗
π∗ is 'trend' output, so that -
where is inflation, is the inflation target, is output and is the output
πt xt xt xt xt
r The policymaker's objective is to minimise the discounted sum
gap, and subscripts denote time periods.13
of these losses over time. In this formulation, a lambda of zero would imply no weight on the stabilisation of
- "inflation nutter" preferences. When lambda is positive, in contrast, the policymaker is
real activity so-called
willing to strike at least some trade-off between output and inflation stabilisation, as directed by the MPC
remit.
This objective function is optimised subject to the constraints implied by the aggregate behaviour of the
economy, including the relationship between interest rates and activity; and the relationship between activity
-
and inflation the Phillips curve shown in Figure 1. In essence, these suggest lower interest rates raise
activity;14 and higher activity generates higher inflation.
Under this simple framework, in certain circumstances, the optimal policy balances inflation overshoots with
shortfalls of activity relative to potential, and vice versa for inflation undershoots. (A derivation appears in the
Annex.) The relative size of these two deviations is governed by the strength with which higher output
translates into higher inflation; and the preferences of the policymaker, or:
κ
- π∗ = - - ∗)
πt (xt xt
κ
κ
where is the effect of the output gap on inflation. From this, it is clear that the higher is lambda, the greater
the weight placed on output stabilisation and the more a given shock is allowed to flow through to inflation.
As lambda shrinks to zero, the policymaker becomes an inflation nutter, with all of the adjustment to a shock
forced through the output gap in order to keep inflation very close to the target.
13
A "micro-founded" loss function resembling this can be derived in New Keynesian models, in which lambda is a function of the
underlying deep parameters in the economy (such as those governing the degree of price stickiness). These are typically based on the
representative agent assumption. A newer literature drops representative agent assumption. In this case, the
"micro-founded loss
function" contains additional terms capturing some aspects of heterogeneity between households. For example, in a model with
borrowers and savers, a term in the loss function containing the "consumption gap" arises -
measuring the gap between the
consumptions of the two types of household. The reason terms like this appear is that dropping the representative agent assumption
also to introduce additional frictions, like borrowing constraints. In the example given here, the "consumption gap"
tends represents the
(borrowers can't smooth consumption as easily). Strictly speaking, this is
welfare loss due to imperfect risk-sharing something the
"social planner" should care about, even if the central bank, with a
narrowly-defined inflation mandate, does not.
14
Lower interest rates, that is, relative to the equilibrium or "natural" interest rate.
The slope of the trade-off is also affected by that of the Phillips curve. When the Phillips curve is flatter,
output gaps of a given size result in larger inflation over- or under-shoots.15 Intuitively, a flat Phillips curve
makes the output costs associated with moving inflation around higher. As a result, a flatter Phillips curve
means the policymaker will optimally choose to allow inflation to be further away from the target than if the
Phillips curve were steeper.
3. Lambda, lambda, lambda
-
What does past behaviour reveal about the preferences of policymakers the value of lambda?
Chart 5: Inflation very high and very volatile In the 1970s and 1980s, monetary policy was, for the
prior to inflation targeting
most part, trained neither squarely nor credibly on
Inflation
28
(%)
inflation control. As a result, the inflation outcomes
26
over this period ranged from poor to risible (Chart 5).
Pre Inflation
24
Targeting
22
From 1971 to 1992, retail price inflation averaged
20
9.5%, with a standard deviation of 5.6%. Over the
18
16 same period, unemployment averaged 7.6%, with a
14
standard deviation of 2.8%. Soon after the adoption of
12
inflation targeting, unemployment fell by one
10
percentage point and its standard deviation was cut in
8
half. The volatility in economic growth rate in the
6
4 1970s and 1980s was also one-and-a-half times
2
higher than after the adoption of inflation targeting. In
-6 -4 -2 0 2 4 6 8
0
Output gap (%) sum, high, volatile inflation likely contributed to a
Source: Bank calculations. Inflation is the annual growth rate of
higher natural rate of unemployment and poor supply
the retail price index (RPI) until 1975, and the annual growth
rate of the retail price index excluding mortgage interest
side performance.
payments (RPIX) after 1975. The output gap is the percentage
deviation of quarterly GDP from its trend, where the trend is
measured by a Hodrick-Prescott filter.
Once the UK adopted inflation targeting and granted
operational independence to the Bank, consistent with the theory of constrained discretion, the UK moved
towards a better equilibrium characterised by low, stable and predictable inflation, and relatively stable
employment. Moreover, by successfully anchoring inflation expectations around the target, inflation targeting
helped lower UK borrowing costs for households and businesses, and has allowed monetary policy to
promote short-run stabilisation of the economy. In other words, some trade-off between inflation and output
has become possible and lambda has become relevant.
As I mentioned earlier, the period of inflation targeting can be divided into pre- and post-crisis periods.
During the Great Moderation, the economy's supply capacity grew at a
steady pace, and, for the most part,
15
In New Keynesian models, the slope of the Phillips Curve is related to the deep parameters governing the frequency with which firms
their prices, following the formalisation of Calvo (1983). See Calvo, G (1983), "Staggered prices
are assumed to be able to re-optimise
Journal of Monetary Economics, 12.
in a utility-maximising framework",
deviations of inflation from target reflected temporary disturbances to demand that were expected to drive
output and inflation in the same direction (Chart 1).16 Generally, monetary policy faced few trade-offs; divine
coincidence largely ruled.
The crisis brought shocks both to demand and supply, higher inflation and large shortfalls in output and
employment. The era of divine coincidence was over and the MPC had to balance a series of challenging
trade-offs (Chart 2).
What can be learned about lambda from this era? Taking these trade-offs at face value suggests a value of
lambda of between 0.1 and 0.2 for the inflation targeting period as a whole, on the basis of data outturns
(Chart 6) and on the basis of MPC forecasts (Chart 7).17 For the post-crisis period alone, when the monetary
policy trade-off was particularly stark, lambda is estimated to be around one-quarter, also on the basis of
both outturns and forecasts.18 In other words, the MPC tolerated a period of above-target inflation in order to
support the real economy. When combined with an average Phillips Curve slope, this implies deviations of
the output gap from zero that are around half the size of those of inflation from the target.
Chart 7: ... with similar values implied by MPC
Chart 6: Data outturns are consistent with a
value of lambda of between 0.1 and 0.2 for the forecasts since independence
inflation-targeting era as a whole, and around
period...
1⁄4 for the post-crisis
Great moderation
Inflation deviation from target (pp)
Inflation
6
1.0 Great moderation
(%)
Financial crisis and after
Financial crisis and
after
0.5
4
0.0
-1 -0.5 0 0.5 1 1.5 2
Cumulative
growth, relative
2
-0.5 to trend (%)
-6 -4 -2 0 2
Output gap (%)
-1.0
0
-1.5
-2
-2.0
Source: Bank calculations. Notes: Chart shows inflation deviation from target at the 2-year
forecast horizon against cumulative growth, relative to trend, as
a proxy for the output gap.
16
Typically, these demand disturbances were well signalled by survey measures of activity, resulting in a high correlation of these and
Bank Rate Ref Broadbent.
17
Inferring policy preferences from the MPC's
published forecasts in this way is not necessarily straightforward, however, because the
MPC's forecasts are conditioned on the path for interest rates. Implicitly, then, the assumption would be that the MPC's
market-implied
forecasts and reaction function are, on average, well understood by the market.
18
This assumes a Phillips Curve slope, κ, of 1⁄2. The lines of best fit in Charts 1 and 2 have slopes of around minus 0.3 for the period as
κ = κ
a whole and minus 0.55 over the post-crisis period. With a value of 0.5, this suggests of between 0.1 and 0.2 for the whole period
and κ of around 1⁄4 for the crisis period alone.
To put this into some context, consider the stated and revealed preferences of the FOMC. Chair Yellen has
referred to a "balanced approach" to trade-off management, implying equal weights on inflation deviations
and the unemployment gap.19 Econometric studies for the US provide a range of estimates for lambda,
centred around 1⁄2 albeit with significant estimation uncertainty, with some studies finding evidence that the
FOMC's implied lambda has also varied over time.20
Why there isn't a simple rule to achieve society's inflation objective?
4.
This exercise illustrates how the MPC has sought to do what society has asked. Within limits, it has
tolerated periods of above-target inflation in order to support the real economy, while at all times respecting
the primacy of the inflation target.
That said, it is important not to over-interpret these results. Specifically, the MPC's average revealed lambda
in the past does not reveal a simple monetary rule that can govern decisions regarding inflation control in all
scenarios in the future.
I stress this point because some have suggested monetary policy ought to follow, or be evaluated against, a
simple rule, such as a Taylor (1993) rule.21 But it is important to recall that, while such rules were estimates
actual - -
of stances of past policy positive descriptions of central bank behaviour they have been re-
-
interpreted as guides for what the central bank should do in all circumstances normative prescriptions.
Taking the past as a strict guide to the future is to assume that the nature shocks does not change and that
the structure of the economy remains constant.
Such stability is hard to square in an era of financial crises; deep, variable technological change; and
potentially large shifts in openness. In a changing world, monetary policy decisions would more properly
emerge from optimal control approaches to monetary policy, which respect the different nature of shocks and
circumstances which the monetary authority must weigh in setting its strategy.
estimating the MPC's lambda
The time-variation of lambda is illustrated in part by the fact that the regression
leaves around two-thirds of the variation of inflation over the output gap unexplained, even in expectation
isn't
and over the post-crisis period. So why the estimated lambda fixed, and what considerations inform its
value in practice?
19
Yellen, J (2012), "Revolution and Evolution in Central Bank Communications", November.
Converting this to an equivalent value for
the weight on the output gap depends on the Okun's law coefficient one assumes, estimates for which vary.
20
Ilbas (2012) estimates the Smets-Wouters model under optimal commitment policy for the Volcker/Greenspan era and find a value of
lambda on output growth of around 1⁄2. Dennis (2006) uses a semi-structural model and finds a weight of around 3 on the output gap,
whereas Givens (2012) estimates a value of around 0.1 over a similar sample. Givens and Salami (2015) estimate a small New
Keynesian model on post-Volker data and find a lambda on the output gap of around 1⁄4. Sack (2000) finds a weight of around 0.8 on the
unemployment gap over the period 1984-1998 using a VAR to describe the economy's dynamics. Lakdawala (2016) allows for time
variation in central bank preferences and finds that the weight on inflation relative to the output gap to have fluctuated over time, falling
to low levels in the 1990s and early 2000s (implying a high relative weight on the output gap), before rising in the period leading up to
the financial crisis.
21
Taylor, J (1993), "Discretion versus policy rules in practice", Carnegie Rochester Series on Public Policy, 39.
First, any lambda that can be estimated from simple scatter plots is actually an amalgam of several
elements. Most fundamental is the policy remit itself, which frames the 'true', underlying preferences that the
monetary authority must pursue, as I discussed earlier. As important, however, is that the actual trade-off
struck will be influenced by individual MPC members' views of both the nature of the shocks hitting the
-
economy and the transmission mechanism of monetary policy in other words, why the economy is
behaving as it is, and how interest rates affect output and inflation. Put another way, if members have, for
- -
example, different views of kappa the slope of the Phillips curve their lambdas will appear to be different.
Indeed, it is quite possible for the Phillips curve slope to vary over time, and some have argued that it may
have flattened in recent years.22
A close reading of the MPC's minutes since its inception reveals the vast majority of differences of opinion
regarding the path for monetary policy have originated in this second set of factors (the nature of the shocks,
the structure of the economy and the monetary policy transmission mechanism). Disagreements about the
desired path for policy have arisen because of different views of how the economy is ac