Message from the President

The spirit of the 2006 Annual Report essay is that macroeconomic theory has had a profound, but rather subtle, effect on monetary policy. One might wonder why such an essay was prepared; after all, we should expect a confluence of theory and practice over time with the results apparent in the evolution of policy. This seems obvious, but many practitioners have asserted that the theoretical insights of the past 30 years or so have had no influence on day-to-day policy advice and decision making.

Authors V. V. Chari and Pat Kehoe convincingly make the case for the value and impact of theoretical developments but, if anything, they understate it. Perhaps the key sentence in the essay comes at the end of the penultimate paragraph, where they write: “It is easy to see why those economists caught up in the whirlwind of day-to-day policymaking miss the dramatic changes in policy that result from slow, secular changes in institutions, practices, and mind-sets.”

The critical word here is “mind-sets.” As a practitioner for better than 30 years, I can attest to the significant and fundamental change in mind-set that has characterized Federal Reserve monetary policy. To get a definitive sense of this, take a look at the Federal Open Market Committee transcripts from, say, 1971, with their embarrassing emphasis on the intractability of cost-push inflation and their confidence in naive Phillips-curve trade-offs. Or consider that 20 years ago, rational expectations theory was still considered an academic curiosity by most policymakers, whereas today it is part of the standard tool kit. More broadly, as Chari and Kehoe describe, progress in economic theory has appreciably altered the way in which macroeconomic issues are framed, the way in which models of the economy and their outcomes are viewed, and the basic choices available to policymakers. All of this has materially influenced decision making.

To be sure, practical experience with difficult real-world policy issues has affected the academic research agenda as well. Thus, there is a “chicken and egg” issue here in terms of: Did experience determine the research agenda or did research foreshadow policy? But this issue, though real enough, is not a problem, for we should expect, and strongly prefer, that both academic researchers and practitioners learn from each other. And they do. Here again, I reference my experience as a policymaker who has benefited from the counsel of top-notch theoretical macroeconomists. This year’s Annual Report authors are representative of a Minneapolis Fed Research unit that, over the years, has been committed to the latest theoretical work, however far removed such theory may have seemed from policy. Often, in the end, this theoretical research not only informed policy, it shaped it.

As always, I hope you enjoy this year’s Annual Report essay, and I welcome your comments. Also, please note the report from Jim Lyon, first vice president, on the status of our Bank’s operations.

Annual Report Essay:   Modern Macroeconomics in Practice: How Theory Is Shaping Monetary Policy