“Having looked at monetary policy from both sides now, I can testify that central banking in practice is as much art as science. Nonetheless, while practicing this dark art, I have always found the science quEite useful.” 2 Alan S. Blinder

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I develop a general equilibrium model with sticky prices, credit constraints, nominal loans and asset prices. Changes in asset prices modify agents ’ borrowing capacity through collateral value; changes in nominal prices affect real repayments through debt deflation. Monetary policy shocks move asset and nominal prices in the same direction, and are amplified and propagated over time. The “financial accelerator ” is not constant across shocks: nominal debt stabilises supply shocks, making the economy less volatile when the central bank controls the interest rate. I discuss the role of equity, debt indexation and household and firm leverage in the propagation mechanism. Finally, I find that monetary policy should not target asset prices as a means of reducing output and inflation volatility. “The population is not distributed between debtors and creditors randomly. Debtors have borrowed for good reasons, most of which indicate a high marginal propensity to spend from wealth or from current income or from any other liquid resources they can command. Typically their indebtedness is rationed by lenders [...] Business borrowers typically have a strong propensity to hold physical capital, producers ’ durable goods. Their desired portfolios contain more capital than their net worth — they like to take risks with other people’s money. Household debtors are frequently young families acquiring homes and furnishings before they earn incomes to pay for them outright; given the difficulty of borrowing against future wages, they are liquidity-constrained and have a high marginal propensity to consume ” (James Tobin, “Asset Accumulation and Economic Activity”, 1980)

draft of this paper is available by ftp from

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Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management. My plan is to review the theory and evidence leading to this conclusion. Section I outlines the general logic of quantitative welfare analysis, in which policy comparisons

This paper integrates the modern theory of unemployment with a limited participation model of money and asks whether such a framework can produce correlations like those associated with the Phillips curve as well as realistic labor market dynamics. The model incorporates both monetary and real shocks. The response of the economy to monetary policy shocks is consistent with recent evidence about the impact of these shocks on the economy. Key words: Monetary policy; liquidity effects; job creation and job destruction

This essay begins with a sketch of some ways I find it useful to think about science and its uses. Following that, the essay applies the framework it has sketched to discussion of several aspects of the recent history of of macroeconomics. It considers skeptically the effort by some economists in the real business cycle school to define a quantitative methodology that stands in opposition to, or at least ignores, econometrics “in the modern (narrow) sense of the term. ” It connects this effort to the concurrent tendency across much of social science for scholars to question the value of statistical rigor and increasingly to see their disciplines as searches for persuasive arguments rather than as searches for objective truth. The essay points to lines of substantive progress in macroeconomics that apparently flout the methodological prescriptions of the real business cycle school purists, yet are producing advances in understanding at least as important as what purist research has in fact achieved. Science as Data Reduction Advances in the natural sciences are discoveries of ways to compress data concerning the natural world-- both data that already exists and potential data-- with minimal loss of information. For example Tycho Brahe accumulated large amounts of reliable data on the movements

This paper puts forward a characterization of the structural features of the economic system relevant to the monetary-policy decisions of the European Central Bank. The econometric analysis adopts a parsimonious VAR representation of three key macroeconomic variables (interest rates, prices and GDP) aggregated across countries to obtain area-wide time series. The exogenous disturbances driving the multivariate system are identified imposing restrictions based on economic theory. The dynamic properties of the estimated models are analyzed and compared with the available evidence for the US. The robustness of this characterization is corroborated by the estimates from a different sample period and by the findings from an alternative model that singles out German monetary policy in view of its anchor role within the ERM. ECB Working Paper No. 2 . May 1999 1 1