Monetary Policy and Economic School of Thought

Thursday, April 9, 2009

Monetary Policy and Economic School of Thought. The influence of monetary policy on output and prices is a long debate concerning both theoretical and empirical terms. This is not detached from the economic development school of thought from start Classical, Neo-classical, Neo-classical synthesis, New Classical and New Keynesian.
In Classical view, money affect only the price and not to the output. By using analysis general equilibrium, included money in the model showed the money neutrality that money does not affect on market equilibrium. On the other hand, the Keynesian view of money affects prices and output because of the price rigidity and involuntary unemployment. This view is modeled on the IS-LM for the equilibrium of money market and goods market and disequilibrium on the labor market.
In the 1960s there consensus view that the money may affect output and prices in the short term (Neoclassical Synthesis). In that period, structure of the labor market is replaced with Phillips curve as aggregate supply. Neoclassical Synthesis model explained that the occurrence of rigidity prices and wages because of the assumptions in determining the behavior of company that is the price mark-up of wages. Although the real wage is flexible, but the pricing behavior conducted in the mark-up so lead to occurring rigidity wages and prices and then money supply affect real output and prices.
Expectation economic agent face economic uncertainty will influence macroeconomic. Two important hypothetical of expectation in the economy are rational expectation and adaptive expectation. Milton Freidman (1957) introduced the adaptive expectation that the expectation economic agents formed by observations of inflation at this time. Phenomenon of the Phillip curve was challenged by Friedman points out that the argument only unanticipated inflation are affecting unemployment. He emphasize on the importance of expectation on the aggregate supply so that revised Phillips curve as expectation-augmented Phillips curve.
On 70’s, it is difficult period for the Keynesian. Lucas (1976) and Sargent-Wallace (1975) introduced the rational expectation that assume economic agents use all relevant information to establish expectation or forecast economic variables in the future. So that monetary policy and fiscal policy affects inflation, than expectation inflation also depend on effect those policies. Thus, changes in monetary and fiscal policies affect the changes expectation agent economy. So, the policy evaluation must consider the effects of expectation economic agents.
Lucas (1976) criticize the results of parameter estimation econometric model that is not stable because occurring the changes policy maker behavior, and than expectation of the private agent will also be changed then it will affect the parameters in the econometric model. This critique affect on two, the revised macroeconomic model with rational expectation of entering and strengthening macroeconomic model with micro foundation.
At the 80’s Classical school of thought was extremely dominant. In the New Classical paradigms, Kydland - Prescott (1982) introduced the real business cycle theory (RBC), which begins with microeconomic assumption of household consumption preference, the production firm and market structures. With the intertemporal optimization of consumption of households and future profit of firms and the market is competitive then the solution obtained by dynamic general equilibrium model. They succeeded in making data replication USA. RBC model assume output is always in the natural level of output and all of output fluctuations are the movement of natural level of output itself. The cause of output fluctuations in Prescott point of view is a shock or a change in technology. Similarly, in the RBC model change in money supply does not affect output.
After the 80’s, research on RBC develop in many models. Debate on technology shock provides inspiration for researchers to develop various models incorporate various aspects, among others; oil shock, fiscal shock, monetary model, and the multiple equilibrium model (Rebelo, 2005).
The latest research on the RBC model related to monetary policy is to include elements of nominal wage and price rigidity in the model, so that changes in money supply can affect output. This model, known as Dynamic Stochastic General Equilibrium (DSGE) model. Some researchers Christiano, Eichenbaum and Evans (2003), Woodford (2003), Smets and Wouters (2004); and Laxton and Pesenti (2003) build and estimate DSGE model based RBC with assumptions nominal rigidities in wage and price, including assumption imperfect competition in market labor market and product market.
Another mainstream New Keynesian is the improvement of the Neo-Classical synthesis with incorporate aspects of the rational expectation and strengthening the micro foundations. However, the Keynesian economists still believe the existence of imperfect markets and nominal rigidity can lead to fluctuations (deviation) of output from natural output. Fischer (1977) and Taylor (1980) argued that the occurrence of the nominal rigidity caused staggering of wage and price decisions by firms. The existence of staggering in wage and price lead to adjustments on price level slowly so that changes in aggregate demand impact on output fluctuations.
In New Keynesian paradigms, the economists [Gali and Gertler (1999) and Gali et al. (2001), Roberts (2001), Fuhrer (1997); Linde (2005)] has to learn how to develop a simple model, related, and structural that could explain mechanisms transmission of monetary, especially through the interest rate and the impact on inflation and output. This model is known as model New Keynesian Small Macroeconomics (NKSM) with approach dynamic stochastic general equilibrium that contain aspects expectation and also solid with micro foundation. This simple model is also containing the aggregate demand, price-setting (Phillips) curve, and the reaction of an interest rate policy to output and inflation. This model to realize the basic principle of the role of monetary policy instruments through the nominal interest rate to inflation stabilization.
Technically DSGE models have weaknesses in terms of technique calibration that difficult to create the replication of data in accordance with the actual data, but the advantage that the DSGE model parameter is the "deep parameters" (parameters for the micro variables). While NKSM have benefits to explain economic conditions simpler, but the weakness is difficult to get the relationship between variables significantly because of the unobserved variables or serial correlation.

Paper in Indonesia Language.
Keyword: Classical, DSGE, Economic, IS-LM, Neo-classical, Neo-classical synthesis, New Classical and New Keynesian, Phillips curve, Price rigidity, Rational Expectation, RBC, wage rigidity.


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