will focus on a piece of recent research that i like very much and which has already received much attention at this conference : dale henderson ’ s paper with christopher erceg and andrew levin ( 2003 ). we have learned a great deal in recent years about the effects of monetary policy in dynamic, stochastic, sticky - price models, with michael woodford ’ s recent book ( woodford, 2003 ) perhaps best representing the state of the art. this line of research is potentially of great importance to applied macro modelers, because it addresses areas in which some may feel that our current policy models need to be strengthened, notably the treatment of expectations, the specification of model dynamics, and the relationship of the economic structure to the form of the policy rule. however, naturally enough, the earliest models in this genre have tended to be highly simplified representations of the economy, only loosely matched to the data. like the models themselves, the optimal policy rules derived in the models are often unrealistically simple. for example, in some of these models, strict inflation targeting - a policy of keeping inflation at zero at all times - is the optimal policy. to make these models relevant for applied policy analysis, the natural next step is to add new frictions and more complex dynamics to the benchmark models. the erceg - henderson - levin ( ehl ) paper explores the implications for monetary policy of a plausible complication, the inclusion in the model of nominal wage stickiness as well as price stickiness. as was discussed yesterday, this relatively simple addition makes an important qualitative difference in the policy results. specifically, in the ehl model, monetary policy can no longer achieve a fully optimal outcome but instead faces tradeoffs among its objectives. because the optimal rule in their model is relatively complex and depends on model parameters and shocks, ehl use model simulations to examine the performance of some simple policy rules. interestingly, they find that relatively simple policy strategies can achieve results close to the optimum. the contribution of the ehl paper goes beyond the specific findings ; equally important is the direction that this work sets for the collective research program. erceg, henderson, and levin have shown by example that incorporating additional, realistic frictions into the basic new - keynesian model changes both the behavior of the model and the nature of the optimal policy rule in nontrivial ways. the papers at this conference by canzoneri, cumby, and diba ( 2004 ) and by

benigno and woodford ( 2004 ) both take up the ehl challenge. for example, canzoneri, cumby, and diba consider further complications of the sticky - price, sticky - wage model, including capital investment and habit formation in consumption, while benigno and woodford explore the case in which the steady state of the model is not pareto optimal, as assumed by ehl. this progressive analysis of the implications of alternative assumptions is part of what thomas kuhn called “ normal science. ” the insights from these types of modeling efforts are already informing policy analysis at the board, and their influence will only grow as they become more detailed and realistic. a second important area, one that will always be central to monetary policy, is macro forecasting. because monetary policy works with a lag, the ability of policymakers to stabilize the economy depends critically on our ability to peer into our cloudy crystal balls and see something resembling the future. one of the key variables to be forecast is inflation. a variety of approaches to forecasting inflation are used at the board, of course. one of dick porter ’ s many contributions was to develop a monetary approach to forecasting inflation at medium - term horizons. dick ’ s so - called p - star approach, originally developed with jeffrey hallman and david small and updated in a 2000 paper with athanasios orphanides, combines simplicity with insight. porter ’ s analysis begins with an equation so basic that, at one time at least, it appeared on the california license plate of milton friedman ’ s personal automobile. that equation is of course the quantity equation, mv = py, or money times velocity equals the price level times output. this equation can be used to define a link between money growth and inflation that depends on the evolution of the velocity of money. hallman, porter, and small ( 1991 ) analyzed the predictive power of that relationship under the assumption that m2 velocity is a constant - an assumption that seemed reasonable at the time they wrote, but, as these things are wont to do, broke down soon after they did their initial work. orphanides and porter ( 2000 ) have developed a more sophisticated version of the p - star model, which employs information about the opportunity cost of holding m2 to track the evolution of equilibrium m2 velocity. this approach seems to work reasonably well at predicting inflation at medium - term horizons, and the forecasts of this model are reported routinely to the board of governors. of course, something