Sunday, November 4, 2007

The Taylor Rule and Boom-Bust Cycles in Asset Prices

Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles. Does this sound familiar? I have been making this same point on this blog for some time, particularly with regards to the housing boom bust cycle of 2003-2005 (see here and here). Although it is refreshing it is to read prominent economists taking this idea seriously, I wish they would be a little more vocal about it. I would also point out that Borio and Lowe (2002) and Borio and Filardo (2004) made the same point several years ago. Also, do not forget George Selgin's important work on this issue.


  1. So is there something wrong with
    the political and constitutional set-up of the
    Federal Reserve? Friedman blamed it for the 1930s and the Great Inflation.
    Why does it keep making big policy errors? Isn't the issue far more fundamental than the optimal tweaking of a Taylor rule?

  2. JMK:

    Big question... I will post on it later.