Aggregate Disturbances, Monetary Policy, and the Macroeconomy: The FRB/US Perspective

The U.S. economy is continually buffeted by disturbances originating both within and outside our borders. To assess the influence of such events on employment, inflation, and other measures of macroeconomic performance, economists often use models of the economy—systems of mathematical equations describing the interactions among various measures of activity in the markets for labor, goods, and financial instruments. Although no model can replicate in full detail the complex behavior of the real world, one can construct models that are consistent with both economic theory and historical data. Such models shed light on the way the economy works and how it responds to disturbances and policy actions that are similar to those encountered historically. The FRB/US model of the U.S. economy is maintained at the Federal Reserve Board for use in policy analysis and forecasting. With FRB/US, the Board’s staff can gauge the likely consequences of specific events through simulation analysis—computational ‘‘what-if’’ exercises in which the model is used to predict the outcomes from alternative assumptions regarding fiscal and monetary policy, international conditions, and so forth. In a similar manner, the staff can use model simulations to assess possible implications for economic performance of the full range of disturbances likely to be experienced over extended periods of time. This article examines the properties of the FRB/US model and the ways in which they shape the model’s predictions. To a large extent, the discussion centers on the monetary transmission mechanism—the chain of relationships embedded in the model that describe how monetary policy actions influence financial markets and, in turn, aggregate output and inflation. The quantitative nature of this mechanism is illustrated by estimates of the effect of movements in interest rates and other factors on spending in different sectors and by simulations of the effect of a change in the stance of policy on the economy as a whole. After the discussion of the transmission mechanism, the article considers the ways in which monetary policy influences the macroeconomic consequences of specific events in the FRB/US model by showing how the predicted effects of selected disturbances change under alternative policy responses. Because these disturbances—a decline in the value of the stock market, a period of unexpectedly rapid wage growth, and an adverse shock to the productivity of American firms and workers—differ in their implications for output and inflation, they illustrate some of the choices faced by policymakers in the context of the model. In the final section of the article, these choices are summarized in terms of policy frontiers that show how, past some point, reductions in the variability of inflation are obtained only through increases in the variability of output.