An overview of monetary policy.

• Author: Romer, Christina D.
• Position: Research Summaries

Two features unite much of our recent research. Most obviously, many of the papers deal in one way or another with monetary policy: we have examined both the effects of monetary policy and the mechanism by which monetary policy influences real output. We also have examined the historical record to discover the role of monetary policy in both starting and ending recessions in the United States.

The second, and perhaps more important unifying characteristic of our research is its methodology. Many of our papers augment standard statistical procedures with a scientific analysis of qualitative evidence. This method, which we have dubbed the "narrative approach," involves using government reports, periodicals, and other sources to glean information not reflected in economic statistics. While such qualitative evidence frequently is used by economists in their more casual analysis, a crucial feature of the narrative approach is its systematic use of this evidence.

The Effects of Monetary Policy

To a layman, the question "Does monetary policy matter?" probably seems absurd. Of course it matters - why else would it be front page news every time the Federal Reserve moves interest rates up or down? But to economists, the question is both serious and fundamentally important. Many of our hypotheses about how the economy works imply that changes in monetary policy, especially those that are widely recognized and anticipated, do not matter. Furthermore, the correlation between money and output is not enough to prove that monetary policy matters, because the direction of causation is ambiguous: high growth of the money supply may cause rapid output growth, or rapid output growth may cause banks to lend more, and hence cause increases in the money supply.

Over the last few decades economists have used various statistical techniques to try to skirt the issue of causation, but with only limited success. For this reason, in "Does Monetary Policy Matter?" we turned to the narrative approach pioneered by Milton Friedman and Anna J. Schwartz in their monumental NBER study, A Monetary History of the United States.(1) Friedman and Schwartz's insight was to use additional evidence from the historical record to separate the changes in the money supply that occur endogenously when output rises or falls from those that occur because of policy actions, or more frequently in their prewar period of analysis, policy mistakes.

Our application of Friedman and Schwartz's insight to the postwar era took the following systematic form. Using both the Record of Policy Actions and the Minutes of the Federal Open Market Committee of the Federal Reserve, we looked throughout the postwar era for episodes when monetary policymakers changed their tastes or expectations about inflation. In particular, we identified six episodes between 1947 and 1987 when monetary policymakers decided that the current level rate of inflation was too high, and they were willing to accept output losses to bring it down.

Having identified these six episodes, we then looked at the behavior of industrial production and unemployment in the months following these decisions. We found that real output most definitely declined following these policy changes, even when we controlled for the usual cyclical dynamics of output. Indeed, we estimated that a monetary policy shock leads to a decline in industrial production (relative to its usual behavior) of 4 percent after 12 months, 9 percent after 24 months, and 12 percent at its peak effect, which occurs after 33 months.

In a more recent paper, we find that this conclusion is strengthened by the passage of time.(2) In December 1988 the Federal Reserve again...