Journal of Economic LiteratureVol. XXXIX (June 2001) pp. 562–566

Sims: Review of Monetary Policy RulesJournal of Economic Literature, Vol. XXXIX (June 2001)

A Review of Monetary Policy Rules1

CHRISTOPHER A. SIMS2

THESE NINE papers by seventeenauthors are from a conference about

monetary policy. The papers are by andlarge technically uncompromising yet at-tempt to provide practical advice. Theyrepresent enormous research effort andare full of stimulating ideas. There areenough differences of view to stoke thereader’s interest, but enough commonal-ity of view that the papers provide im-plicit commentary on each other. Eachpaper is followed by a prepared discus-sion, which in some cases has the weightof a paper in itself, and a summary ofverbal discussion at the conference.Most of the papers present models inwhich monetary policy can be evaluated,and they evaluate a common set ofmonetary policy rules. The editor’s intro-duction provides a thoughtful summaryof the volume and of the implications ofthe cross-model comparisons of the ef-fects of the various policy rules, and hisown contribution studies the historicalevolution of monetary policy rules andtheir effects. In short, this is a very goodbook; even economists who ordinarilyeschew conference volumes will want tomake an exception here.

The book is about the Taylor rule.This is a policy rule that specifies

changes in the central bank’s interestrate according to what is happening totwo variables: real output and inflation.The conclusions from the cross-modelcomparison of rules are (ignoring fornow a few dissents):

1) A Taylor rule, like what is estimatedby ordinary least squares from post-1982 U.S. data, performs well in mostmodels.

2) Performance can be improved, interms of inflation and the variabilityof output, by making the coefficientsin the Taylor rule larger, so that in-terest rates are more responsive toinflation and the output gap.

3) An optimized policy rule with a delayin response of one quarter is nearly asgood as a rule with no delay (so thatlags in availability of data are notcrucial).

4) “Simple” rules, containing few lagsand variables, perform nearly as wellas more complicated rules and aremore robust across models.

5) Interest rate smoothing in the formof rules that make the change in theinterest rate, rather than its level, re-sponsive to output gap and inflationperform better than rules in theoriginal Taylor form.

Taylor’s historical analysis confirmsmany of these conclusions by findingthat rule coefficients have grown largeras we approach the last fifteen years, and

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1 Monetary Policy Rules. Edited by John B. Tay-lor. NBER Conference Report series. Chicago andLondon: University of Chicago Press, 1999. Pp. ix,447. ISBN 0–226–79124–6.

2 Princeton University.

that earlier eras with less responsiverules had less good outcomes.

The models all make non-neutralityassumptions that imply monetary policyhas strong real effects. For the mostpart, they include at least some ele-ments of forward-looking behavior.Most assume imperfect competition andsticky prices, so that prices are modeledas responding to expectations of the fu-ture as well as to the current state ofthe economy. Most make some claim toconnecting to data. Two of the papersare based on models in use at centralbanks: the U.S. Federal Reserve Boardand the Bank of England. Two of themodels, those of Rotemberg/Woodfordand King/Wolman, base their policyevaluations on welfare criteria derivedfrom the models, rather than on adhoc weighting of inflation and outputvariation.

Interesting as it is, there are deficien-cies in the analysis in this volume.There is not space here to offer paper-by-paper critiques, but some of thedeficiencies are common across most ofthe papers and discussion. The onesthat seem most important to me are:

1) the lack of attention to statistical fit;2) the uncritical acceptance of the notion

that there has been clear improve-ment in monetary policy, at least overthe postwar period and perhapssteadily over the century;

3) the promotion of monopolistic com-petition optimizing sticky-price mod-els from stories that make us com-fortable with “price equations” toapparently serious foundations forwelfare analysis;

4) the focus, except in one paper, on pol-icy as a “rule” analogous to the decisionrules of dynamic optimization.

How well the models fit the data is notgiven sufficient attention. It is true thatoften macroeconomic models with quite

different policy implications fit nearlyequally well, but analysis of fit to thedata can sometimes be used to help dis-tinguish between models. Some of themodels are so large or complex that de-tailed discussion of their match to dataappears elsewhere, often in unpublishedpapers. This is true of the central bankmodels and of the Rotemberg-Woodfordmodel, for example. In the case of theRotemberg-Woodford model there hasbeen careful attention to fit elsewhere,but the reader of this volume has no wayto compare its fit to that of the othermodels. That comparing fit of such dis-parate, and in some cases complicated,models is challenging makes it all themore important that organizers of aproject like this set some standards forreporting of fit. In this volume con-siderable effort was put into gettingcontributors to consider a common set ofpolicy rules, but no corresponding effortwent into getting them to present com-parable measures of fit to the data. Thisis not uncommon in model comparisonprojects. For example, it characterizesthe two Brookings volumes edited byRalph Bryant et al., Empirical Macro-economics for Interdependent Economies(1988) and Evaluating Policy Regimes:New Research in Empirical Macro-economics (1993). It might be supposedthat the large models in use at centralbanks would have been developed withcareful attention to fit, so that they arereasonably exempt from documentingtheir fit in a forum such as this. My im-pression, from having looked in some de-tail at the Federal Reserve’s model, isthat this supposition is incorrect. Per-haps because it is acceptable to presentmodel results at conferences and in pa-pers without documenting fit, statisticalprocedures underlying policy models areoften quite casual.

To be specific, the model with themost complete reporting of fit is the

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Rudebusch-Svensson (RS) backward-looking structural VAR model. One ofthe conclusions common across thesticky-price forward-looking models isthat policy shows inertia, so that rises ininterest rates tend to persist, producingbetter results. In the RS model suchrules instead produce instability. Onesenses that this result is regarded by theparticipants as an outlier, reflecting theunfashionable non-forward-looking char-acter of the RS model. But if the appar-ent consensus is correct that laterpostwar policy is strongly reactive toinflationary pressures and shows desir-able interest-rate inertia, then the RSmodel’s non-policy sector should em-body public expectations that this is theform of the policy rule. That the RSmodel nonetheless implies that such ruleswould create instability suggests one oftwo conclusions: the RS model is incor-rect, or expectations have a form thatwill make dangerous the transition tothe predicted good performance of astrongly inertial rule. Note that the factthat the RS model is backward-lookingdoes not mean that it is incorrect, evenif behavior is in fact forward looking.The RS identification scheme is consis-tent with forward-looking behavior; it justdoes not explicitly separate expectationsfrom other sources of dynamics.

Another outlier model is the limitedparticipation model presented by Chris-tiano in his extended comment. Thismodel’s fit is not any better docu-mented than that of most of the othermodels, but it implies radically dif-ferent results from the other models,with a high risk that interest rate rulesof all types can produce instability orindeterminacy.

A belief that is apparently commonacross modelers and discussants at thisconference is that policy has changed,in the direction of reacting morestrongly to inflation, since 1979. Tay-

lor’s paper argues that a pattern ofinsufficient responsiveness of policy toinflation can be found in U.S. data evenbefore the founding of the Federal Re-serve. Rudebusch and Svensson make apoint of documenting that standardtests do not reject the stability of thecoefficients of their non-policy pair ofequations across their entire sample,and claim, without documenting theclaim, that monetary policy behaviorhas not been stable over their sample, sothat a policy rule fit with constant coef-ficients over their entire sample is un-reasonable. That this belief is so widelyaccepted is surprising.

There is one clear shift in regime inthe record of U.S. postwar monetarypolicy. During the period from October1979 through about December 1982,the federal funds rate was much moreunpredictable than before or after.However, an ordinary Chow test for sta-bility of coefficients across the entireRS 1961:1–1996:2 sample (my own cal-culations; RS do not report such a test),with 1979:4–1982:4 omitted, shows noevidence whatsoever of change in theform of the regression. Point estimatesdo suggest a stronger response of inter-est rates to inflation after 1982 thanbefore 1979:4, but there is enoughnoise in the regression, and shortenough subsamples, so that these ap-parent differences are well within therange of sampling error.

Taylor’s analysis is based on fittingTaylor-rule regression equations withinterest rate as dependent variable to anumber of historical periods, comparingthe coefficients and interpreting themas describing policy reactions. Whilethe results are of some interest as de-scriptive statistics, it seems difficult tosupport Taylor’s interpretation of them.In general, interest rates enter manybehavioral relations in an economicmodel, and we therefore cannot expect

564 Journal of Economic Literature, Vol. XXXIX (June 2001)

to recover policy behavior by single-equation statistical methods. The as-sumption widely (probably too easily)adopted for analysis of postwar datawith structural VARs (and in most othermacro models recently) is that interestrates enter the non-policy block of theeconomy only with a lag. Recursive for-mulations, which are common in thestructural VAR literature (but not inmost of my own work) and elsewhere,assume in addition that all variables inthe model are predetermined in the in-terest rate equation, so that OLS recov-ers the policy reaction function. Thisassumption “works” with postwar data,probably because during this periodpolicy makers by and large did set inter-est rates. But in other periods, particu-larly during variants of the gold standard,any regression of interest rates on out-put and inflation must be a mixture atleast of policy behavior and moneydemand behavior, and this makes itunlikely that policy rules will be estima-ble with single equation methods. Infact recursive structural VARs don’t“work” on interwar data; specificationsthat allow for simultaneity are required.During gold-standard periods, priceswere more volatile than they are todayand inflation tended to be short-lived.Any monetary policy that produced thisoutcome would be likely to imply, viathe Fisher relation, that nominal inter-est rates would respond less than propor-tionately to realized inflation in a regres-sion equation. I remain unconvincedthat Taylor’s analysis is demonstratingmore than this.

Most of the models reported in thebook have “forward-backward” pricedetermination equations, in some casesderived from optimizing behavior. Weshould remind ourselves of how precari-ous the foundations of such equationsare, despite their current ubiquity.Though their popularity rests in part on

the idea that their use avoids the Lucascritique, in fact it is unlikely that thearbitrary price-non-neutralities intro-duced into “technology” in such mod-els—contract lengths, menu costs,etc.—are invariant to the stochasticprocess followed by prices. Also, asRobert Hall pointed out in a brief butimportant comment in the general dis-cussion during the conference, thesemodels imply that firms with stickyprices are offering unbounded call op-tions. That is, they are offering to sell asmuch of their product as the market de-mands at their “stuck” price, no matterhow long their price is stuck. This is notthe way actual sticky prices work. Evenin retail catalogs, everyone understandsthat an attractively priced and popularproduct may sell out, and that the sellerhas no obligation to provide arbitraryamounts of the product at the quotedprice. In fact, stockouts often provide theoccasion for a price change. This is im-portant, because two of the papers in thevolume, those by Rotemberg/Woodfordand King/Wolman, rely on the unlimitedcall-option feature of these models toderive welfare conclusions. The welfarecosts computed in these papers ariseentirely from the fact that inflationinefficiently expands production ofrelatively low-priced firms “stuck” atold prices relative to higher pricedfirms that have adjusted prices. It is notat all clear that this is in fact even agood metaphor for the main costs ofinflation.

Most of the volume takes for grantedthe usefulness of characterizing policyin terms of a “rule,” by which is meantan equation with an interest rate deter-mined by some variables measuringthe state of the economy. The RSpaper makes a case for thinking abouta rule in a different way. We can thinkof a rule as determined by a policymaker’s objective function, defined

Sims: Review of Monetary Policy Rules 565

over projected paths of output and in-flation over the next year or two. Thepolicy process involves projections ofthe consequences of various sequencesof possible policy actions, using a modelor models, and choice among theseprojections by policy makers. Of coursethis process is exactly the sort thatKydland and Prescott argued wouldlead to an inferior high-inflation equi-librium. But that outcome depends onpolicy makers naively ignoring the factthat inflationary expectations are impor-tant and may be costly to unravel oncethey are in place. Policy makers areprobably averse to even modest infla-tion mainly because they recognizethat, unchecked, it can quickly lead tohigh inflation, not because modest in-flation is in itself extremely costly orunpopular. RS show that policy makerswho dislike high unemployment, buteither put high value on low inflation orconstrain themselves to policy pathsconsistent with a return of inflation totarget levels in a one- or two-year timeframe, will produce good outcomes intheir model. Of course, the behavior ofsuch policy makers could be describedas a regression equation rule of theusual sort. But as RS point out, theirway of formulating the rule is likely tobe better understood by policy makersand the public, more robust to drift inthe structure of the economy over time,and more directly adaptable to a situ-

ation of model uncertainty. Perhapsmost important, because a rule formu-lated this way is easy to understand, itis probably easier to make credible.Which policy announcement is morelikely to be believed and incorporatedimmediately into expectations: “We areraising the coefficient on lagged infla-tion in the Taylor rule from 1.5 to 2.1,”or “We have decided to start choosinginterest rate paths consistent with a re-turn to our inflation target in one year,instead of the previous eighteenmonths”? Especially if the latter type ofpolicy announcement were accompa-nied by an explicit projection of thefuture time path of the federal fundsrate and inflation rates, it would likelyquickly impact financial market andwage and price setting behavior. “Infla-tion targeting” in practice at centralbanks around the world is at leasttending in the direction of this way offormulating and announcing policy. Itseems to me that the call by RS forthinking about rules this way is one ofthe most important ideas in the book.

This book is rich enough that inmaking these criticisms of some of itsbroad patterns and themes I haveprobably distorted the views of atleast some of its contributors. My ex-cuse is that in doing so I may havestirred up the reader’s interest enoughto read the book and thereby correctmy distortions.

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This article has been cited by:

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2. Denise Cote, John Kuszczak, Jean-Paul Lam, Ying Liu, Pierre St-Amant. 2004. The performanceand robustness of simple monetary policy rules in models of the Canadian economy. CanadianJournal of Economics/Revue Canadienne d`Economique 37:4, 978-998. [CrossRef]

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