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Economic Review

Economic Review
C O N T E N T S
Fourth Quarter 2001/Volume 86, Number 4

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

GERALD P. DWYER JR.
Vice President, Financial

JOHN C. ROBERTSON
Assistant Vice President, Regional

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

LYNN H. FOLEY
Editor

NANCY PEVEY
Managing Editor

CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Designers

ALISON BOUNDS
Marketing and Circulation

CHARLOTTE WESSELS
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank's Public Affairs Department with a copy of any publication containing reprinted material.

Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470 (404/498-8020). Internet: http://www.frbatlanta.org. Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new information.

ISSN 0732-1813

On Business Cycles and Countercyclical Policies
Marco A. Espinosa-Vega and Jang-Ting Guo

Since the third quarter of 2000, the U.S. economy began to experience a slowdown in its rate of growth. This slowdown serves as a reminder that the business cycle is still alive and raises the following questions: What do we know about the driving forces behind the business cycle? What should policymakers do in the face of economic fluctuations?

The authors examine two explanations for business cycles that are well-known in academic circles: the animal spirits theory and the real business cycle theory. The former is closely connected with the Keynesian economic tradition and identifies market participants’ mood swings as the key source of economic fluctuations. The second explanation is rooted in the classical economic tradition and views productivity shocks as the driving force behind economic fluctuations. The article then looks at what these theories suggest about countercyclical policies, which try to eliminate business cycle fluctuations or insulate market participants from their effects. The authors conclude that neither theory makes an unambiguous case supporting countercyclical policies.

This conclusion may come as a surprise to government and business economists who have an ingrained belief in the benefits of such policies. It is important to remember, however, that attempts to understand business cycles and the effects and desirability of policies that may (or may not) moderate them are still at a very early stage.


What Remains of Monetarism?

R.W. Hafer

In October 1979 the Federal Reserve, in an attempt to curb double-digit inflation, announced that it would place more weight on monetary aggregates in policy deliberations. This policy shift helped reduce inflation but sent the economy into a recession. Three years later the Fed abandoned monetary targets and returned to targeting the federal funds rate.

Monetary growth targets currently play no official role in the setting of U.S. monetary policy. Is such disregard justified by the data any more today than it was twenty years ago? This article provides a historical perspective on the development and apparent failure of monetarism as a policy guide.

The author also explores whether the basic monetarist propositions still hold true for a sample of fifteen countries. The analysis suggests that it is premature to dismiss monetary aggregates as uninformative. The data from the economies studied indicate that, in general, nominal income growth and inflation are positively related to money growth. While these results do not support short-term manipulation of the monetary aggregates to deliver precise control over movements in income and prices, they also do not reject the notion that changes in money growth have important long-term effects on the economy. What the results suggest, therefore, is that failure to acknowledge this empirical fact could lead to undesirable policy consequences.


Assessing Simple Policy Rules: A View from a Complete Macroeconomic Model
Eric M. Leeper and Tao Zha

Monetary policy analysts looking for a model on which to base decisions may consider two popular approaches—the New Keynesian (NK) and the identified vector autoregression (VAR) approaches. Choosing between the two can be difficult: NK models are stylized and have simple rules while structural VAR models have complex dynamics and loose behavioral interpretations.

The simpler NK models often produce stark conclusions. For example, NK analyses consistently find that the Federal Reserve’s monetary policy has improved markedly in the past two decades compared with the 1960s and 1970s. In contrast, VARs find little instability in the policy parameters or in the dynamic impacts of exogenous shifts in policy.

Taking the view that NK models are simply restricted VARs, the authors estimate systems of structural equations implied by NK models. They find that these estimated equations vary considerably over different periods. The authors also investigate the role of money by incorporating money (M2) into the NK model; they find that including money substantially alters the model’s conclusions about monetary policy. This result conflicts with the NK theoretical assumption that money is irrelevant.

Both NK models and VARs have their place in policy advising, the authors believe. But they caution that it is treacherous to draw inferences about policy effects solely from policy rules estimated in isolation from a complete macro model.