Timeless Perspective vs. Discretionary Monetary Policy in Forward-Looking Models

Recent analysis by Clarida, Galí, and Gertler (1999), Jensen (2002), Svensson and Woodford (1999), Walsh (2002), and especially Woodford (1999a, 1999b, 2000) has been highly productive in advancing the profession’s understanding of optimal monetary policy. Specifically, these papers emphasize the importance for policy purposes of the distinction between macroeconomic models (of private behavior) that are “forward looking”—i.e., have equations that include expectations of future values of endogenous variables—and those that are not. This distinction—applied to the structural form of the model—is of great theoretical significance, since models derived from optimizing analysis almost invariably include expectations of future variables. A major point of the cited literature is that there is, in forward-looking models, an inefficiency that results from discretionary policymaking, relative to that of a well-designed policy rule, that obtains in addition to the familiar inflationary bias. (The inflationary bias has been extensively discussed in a huge literature that typically uses non-forward-looking models.) This point, which is implicit in earlier work by Currie and Levine (1993), among others, has been valuably emphasized in the cited papers, especially Woodford (1999b).