Choosing the Right Policy in Real Time (Why That’s Not Easy)

As an economist, you make policy recommendations at any point in time that depend on what model of the economy you have in mind and on your assessment of the state of the economy. One can see these points play out in the current discussion about the timing of interest rate liftoff and the speed of the subsequent renormalization. If you think nominal rigidities are not all that important, you are likely to conclude that accommodative policies won’t do much for growth but will generate inflation. Similarly, if you are convinced that the economy is already firing on all cylinders, you may see little need for prolonged accommodation. The problem is, you are not quite sure about the state of the economy or what the right model is. If you are a Bayesian, you may want to try to put probabilities on different models/states of the world and take it from there. The first post in this series, “Combining Models for Forecasting and Policy Analysis,” introduced a procedure called dynamic pools that shows how to do just that. In this post, we apply that procedure to a policy exercise. We can’t publicly discuss current policies, so we will instead apply our method to consider alternative monetary policies at the onset of the Great Recession.