In my previous post, I looked at the development of modern macroeconomics. Several commenters responded by discussing what they thought was wrong with macro. Here I’ll put in my own two cents, and then explain how my views relate to those of my commenters.

In my view, the biggest problem with modern macro is the treatment of monetary policy.  Simply put, modern macroeconomists don’t know what monetary policy is.  

Of course I’m slightly exaggerating.  Economists have a general idea as to what the term monetary policy means, but the concept remains frustratingly vague.  Exactly what is monetary policy?  I feel so strongly about this issue that I recently published an entire book on the subject.

Here are a couple excellent comments from the previous post:

Thomas Hutcheson:

For me the biggest failing of macro modeling is leaving out (leaving implicit) the Fed’s reaction function. It the modeler guesses right, then the model can be useful in examining other variables, fiscal “policy” for example or shocks to the price of petroleum.

Michael Sandifer:

The most disappointing thing about the development of macroeconomics to me, as a non-economist, is the lack of progress at understanding the intersection of macroeconomics and finance, particularly with regard to liquid asset markets.  

What is the fiscal multiplier?  Without knowing the Fed’s reaction function, that’s not even a coherent question. Suppose the Fed were an NGDP targeter.  If fiscal policy changed, then the Fed would adjust its interest rates target so that NGDP growth would be expected to remain on target.  In that case, in what sense is there any “fiscal multiplier”?  And even if interest rates are stuck at zero (as in late 2012) the Fed adjusted other tools like forward guidance and QE in order to offset the impact of fiscal austerity.

If you argue that the fiscal multiplier is the effect of fiscal policy on GDP holding monetary policy constant, then you must define what you mean by “monetary policy”.  The money supply?  The nominal interest rate?  The real interest rate?  The gap between the policy rate and the natural interest rate?  There are lots of possibilities.

In my view, there is only one useful definition of the stance of monetary policy—the expected future level of the nominal aggregate being targeted.  If NGDP is the target (which is my preference), then the future expected level of NGDP measures the current stance of monetary policy. 

Sandifer is correct that macroeconomists pay too little attention to financial asset prices. Any efficient estimate of future expected NGDP would involve at least some financial asset prices.  In a perfect world, we’d have a highly liquid NGDP futures market.  The price of NGDP futures would represent the current stance of monetary—which would move around in real time.  Even without this market, we can look at a wide range of other asset prices (including things like TIPS spreads) and infer a rough estimate of the market forecast for NGDP growth.

Macroeconomics will never become a mature field until we get serious about defining the stance of monetary policy.  Step one is to abandon interest rates as an indicator of policy and move on to more promising alternatives—especially market forecasts of future NGDP.