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Business
Review
Federal Reserve Bank o f Philadelphia
M a rc h -A p ril 1991




ISSN 0007-7011

Business
Review

The BUSINESS REVIEW is published by the
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edited by Patricia Egner. Artwork is designed
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2


MARCH/APRIL 1991

HOW ACCURATE ARE
QUALITY-OF-LIFE RANKINGS
ACROSS CITIES?
Joseph Gyourko
Early rankings of cities by quality of life
relied solely on such amenities as beaches
and sunshine. Then economists added
fiscal variables—local taxes and publicly
provided services—to the measures. A
recent study of quality of life measures
the extent to which a city's combined
traits influence wages and land prices. A
ranking of 130 U.S. cities follows. But
how much do these rankings really tell
us?
ACTIVIST MONETARY POLICY
FOR GOOD OR EVIL?
The New Keynesians vs.
the New Classicals
Tom Stark and Herb Taylor
How does monetary policy affect the real
economy? There is little agreement on
this issue, but two groups each think they
have the answer. The New Classicals
believe that monetary policy has an im­
pact on output and employment only
when it catches the public by surprise.
Meanwhile, the New Keynesians claim
that even unsurprising policy actions
can—and do— have a sustained impact.
Can either side claim to know for sure?

How Accurate Are Quality-of-Life
Rankings Across Cities?
Joseph Gyourko*

Q

uality-of-life comparisons across locali­
ties routinely attract the attention of ex­
ecutives, workers, local public officials, and
academics. Private firms, many in relocation
or vacation-related businesses, were the first to
gauge the relative attractiveness of different
areas. These firms gathered data on climate,
culture, employment, home prices, and wages,

’Joseph Gyourko is an Associate Professor of Finance
and Real Estate at the Wharton School of the University of
Pennsylvania. He wrote this article while he was a Visiting
Scholar in the Philadelphia Fed's Research Department.




all of which they thought influenced the qual­
ity of life. Then they weighted these factors in
some ad hoc manner to compute an index
number reflecting the quality of life in each
community.
Many of these earlier efforts tended to inter­
pret low home prices and high wages as evi­
dence of a high quality of life, and the cities
with these traits were rated as relatively more
attractive. But in the late 1970s, economists
introduced an entirely new methodology for
ranking areas that reversed the interpretation
of home prices and wages. Economists tend to
3

B U S IN E SS R EV IE W

view relatively low land prices and high wages
as signs that an area is unattractive. Alterna­
tively, they view high land prices and low
wages as evidence that an area is relatively
more attractive.
In a city such as San Francisco, for example,
land prices are higher and wages are lower
than they otherwise would be because of the
presence of high-quality amenities—good
weather, scenic views, and nearness to the
ocean—for which an entrant to the community
is willing to pay a great deal. The payment is in
terms of higher land prices and/or lower wages
because the people willing to pay the most for
a house and accept the least in terms of wages
are most likely to obtain one of the scarce sites
and jobs in the area. Consequently, you are not
necessarily better off if you live in a highquality-of-life city such as San Francisco. The
reason, of course, is that you have to pay more
to enjoy San Francisco's higher quality of life.
More recent studies suggest that a locality's
quality of life depends on more than amenities.
Locally provided services and taxes have nearly
as much influence on the quality of life as
weather and pollution. Introduction of the
public-service and tax variables into the quality-of-life literature has enabled economists to
put a value on something policymakers long
have claimed is important. The ability to pro­
vide quality service while restraining taxes
improves the attractiveness of a jurisdiction.
While local weather and amenity conditions
usually cannot be altered by the community,
the fiscal climate is under its control. Finally,
the latest evidence also introduces a note of
caution about the preciseness of quality-of-life
rankings. Given limited data, it is still very
difficult to distinguish among most cities' quality
of life.
ESTABLISHING A VALUE
FOR THE QUALITY OF LIFE
The value of any area's special characteris­
tics is determined by what people are willing to

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4
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M A R C H /A PRIL 1991

pay in order to live there— in other words, the
sum of what they are willing to pay for each
local trait that either contributes to or detracts
from the area's quality of life.1
The issue is how to determine the prices of
these local traits. It is not immediately clear
how much people are willing to pay for an
amenity such as extra sunshine. Sunshine is
not a standard good traded in a visible market.
But even though there is no explicit price for
sunshine, there is an implicit one. Assume you
are considering moving into either Commu­
nity A or Community B. These communities
are alike in all respects except that Community
A tends to experience one more day of sun­
shine per year than Community B. Because
sunshine is something you like, you are willing
to pay some positive dollar amount for more of
it. For example, if you are willing to pay $100
more to move into Community A, then that is
the price of the added sunshine you expect to
enjoy in Community A. Because the added
sunshine is the only difference between the two
communities, your willingness to pay the extra
$100 must be due to the sunshine differential.2
CAPITALIZATION INTO WAGES
AND RENTS
There are two ways in which you could pay
your extra $100. One is by bidding up land
prices so that you are able to obtain one of the

Growing interest in this topic has produced the socalled "quality of life" literature. Rosen (1974, 1979) and
Roback (1980, 1982) provided the initial conceptual and
empirical underpinnings for this literature.
2If you are the marginal entrant to the community, $100
is the true implicit market price of sunshine. The marginal
entrant is the person who determines the price. The added
$100 this person is willing to pay is just enough to secure a
site in the community. Other people may place higher valu­
ations on the extra sunshine, but they will not have to bid
more than an extra $100 because they will not have to pay
any more than the marginal entrant. Entrants who value the
amenity more than the marginal entrant does are said to be
inframarginal.

FED ERA L R E SE R V E BA N K O F PH ILA D ELPH IA

How A ccurate A re Quality-of-Life Rankings Across Cities?

scarce housing sites in the community. How­
ever, it is not necessarily true that you will
ultimately pay $100 more for a house in Com­
munity A than you would pay in Community
B. Part of the cost of the added sunshine may
be paid in the form of lower wages than you
would accept in Community B. What must be
the case is that the wage and land price differ­
entials total to the $100 value of the added days
of sunshine you will receive during your stay
in Community A. The extent to which your
wages are lower or your land price is higher is
the extent to which an amenity's value is capi­
talized into the local labor and land markets,
respectively. Precisely how much of the price
of sunshine is reflected in land prices versus
wages depends on supply and demand condi­
tions in the local land and labor markets.3
To measure the local quality of life, econo­
mists attempt to determine the price of every
local trait that potential entrants would find
important. They then multiply these prices by
the quantities of the relevant traits existing in
each community to determine each trait's con­
tribution to the local quality of life. These
prices can be estimated in terms of annual
dollar amounts. If a day of sunshine is worth
$10, and the community typically experiences
100 days of sunshine per year, then the annual
value of the locality's sunshine is $1000 ($10 x
100 days). The total annual value of the local
quality of life is simply the sum of the values of
all the locality's traits. (For more detail, see
Compensating Differential Models and the Quality
o f Life, p. 6.)
THE IMPORTANCE
OF THE LOCAL FISCAL CLIMATE
In addition to amenities, government serv­
ices help determine a locality's quality of life.
3Gyourko and Tracy (1989a, 1989b) and Roback (1980,
1982) provide the details on relative land and labor market
conditions that lead to capitalization into land prices versus
wages.




Joseph Gyourko

These services differ from pure amenities in
that they are produced and have explicit tax
prices. If a service, such as education, is fully
priced via local taxes (in other words, you pay
in taxes exactly what you think the service is
worth), there will be no implicit price for the
service in terms of capitalization into wages or
land prices.
Consider again Community A and Commu­
nity B. Now assume that Community A also
provides a superior education system that you
estimate will be worth $500 per year more than
Community B's education system. If Commu­
nity A charges you $500 more in property
taxes, the education service is fully priced via
taxation. You would not be willing to pay an
added premium to enter the community in
terms of bidding up land prices or accepting
lower wages. However, the absence of any
effect on wages or land prices does not imply
that better education service is worthless or
that it is irrelevant in determining the local
quality of life. The superior education truly is
worth an extra $500 a year to you.
Of course, if the extra taxes in Community A
are less than $500, some of the value of the
superior education will be capitalized in wages
and land rents. To capture the influence of
taxes and services on the attractiveness of an
area, economists control for both in estimating
the quality of life. Recent research suggests
that intercity differences in local fiscal condi­
tions have nearly as much independent influ­
ence on quality-of-life rankings as do differ­
ences in pure amenities.
Public-Sector Unionization. A related is­
sue is whether the nature of local public-sector
labor markets also influences the quality of life
across cities. The past two decades have wit­
nessed a striking increase in unionization among
public-sector work forces. The issue for the
quality of life is whether these highly union­
ized local public-sector work forces obtain
compensation premiums or engage in overstaffing. Consider the land and labor market
5

MARCH/APRIL 1991

BUSINESS REVIEW

Compensating Differentia
Urban economists use compensating differential models to analyze how differences across
communities in amenities and fiscal conditions influence local land prices or wages. The economic
value of a local amenity or publicly provided service is determined by the land price you are willing
to pay and the wage you are willing to accept in order to locate in some jurisdiction. Thus, wages
(W) and land prices (L) in city j are influenced by the quality of local amenities (A), the quality of
publicly provided services (G.), and a series of local taxes (T), as shown in equations (1) and (2):*

(1) Wj = W {A, Gjr T.}
(2)

L. = L{A., G, T}

Estimation of equations (1) and (2) generates regression coefficients, which document by
how much wages and land prices are affected by small differences in taxes or in the quality of
amenities or services. Both land prices (rents) and wages are measured in terms of annual
expenditures (Table 1). Each trait's coefficient is the so-called hedonic, or implicit, price of the trait.

*In practice, housing prices typically are used in lieu of land prices because a consistent land price series does
not exist for most cities. Thus, equation (2) is augmented with a vector of housing quality controls. Workers, not
just housing, differ in quality. Variables controlling for worker quality (for example, education level and
experience), as well as the type of job and industry, normally are included in equation (1). See Gyourko and Tracy
(1991) for these and other details with respect to the estimation of the land price and wage equations. Moreover,
equations (1) and (2) are the reduced forms of a simultaneous system determining wages and rents, and the ultimate
land or labor price of an amenity will depend on its value not only to consumers but to producers as well. For
example, clean air is valued by consumers, but it may reduce productivity for some firms because of the need to
invest in pollution-control equipment. The positive value to consumers would tend to raise land rents while the
cost to firms would tend to lower them. As a result, the net effect could be positive or negative. See Voith (1991).

impacts if Community A and Community B
have equally productive public workers, but
Community A pays its unionized workers a 10
percent premium including better pension
benefits. The higher compensation has to be
financed by higher taxes, either now or in the
future. To compensate for the higher taxes, a
potential entrant into Community A should
insist on a lower price for land and/or demand
higher wages. This capitalization into lower
land prices or higher wages would indicate a
lower quality of life. However, after control­
ling for current taxes and services, recent find­
ings indicate that differences in public-sector

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6
Federal Reserve Bank of St. Louis

unionization levels do not materially affect
land prices or wages.
A RANKING OF CITIES
Economists have used the implicit prices of
amenities and local fiscal characteristics to rank
areas according to their attractiveness.
Blomquist, Berger, and Hoehn, in a 1988 study,
ranked counties by their quality of life using a
standard set of pure amenities. More recently,
Gyourko and Tracy, in 1990, produced a rank­
ing of cities that considers the fiscal climate
along with amenities. They estimated the prices
of traits, then used them to calculate an index
FEDERAL RESERVE BANK OF PHILADELPHIA

How Accurate A re Quality-of-Life Rankings Across Cities?

Joseph Gyourko

;ls and the Quality of Life
Since these local traits are not traded on visible exchanges, their prices are revealed only implicitly
through their impacts on local land and labor markets.
Estimating equations (1) and (2) reveals prices for traits in both the land and labor
markets. It is important to note that each trait's full implicit price is determined by its impact across
both markets. By definition, the full implicit price for trait k (FPk is the sum of its land market price
)
(LPk and the negative of the labor market price (WPk), as shown in equation (3):
)
(3)

FPk = LPk-W Pk

To understand this formula, consider a favorable trait, such as sunshine, and an unfavorable trait,
such as heating degree days. All else constant, a city with more sunshine probably will have higher
land prices and lower wages. Note that sunshine has a positive impact on prices in the land market
and a negative impact on wages in the labor market. Subtracting the negative labor market impact
from the positive land market impact ensures a positive full price for sunshine, as intuition would
suggest.
However, more heating degree days generate lower land prices and higher wages, all else
constant. This is because added heating degree days imply more days with temperatures below a
moderate 72 degrees. These conditions typically are associated with a higher degree of personal un­
comfortableness, as well as higher energy costs. Subtracting the positive labor market price of this
trait leads to its negative full price. Thus, the use of equation (3) means that traits with positive
(negative) full prices are viewed as beneficial (detrimental) by entrants.
The value of the local quality of life simply is the sum (Z) of the value of all the locality's
traits. The basic quality-of-life index (QOL.) is created as follows:
(4)

QOL. = Z (FPk * Tk
j)
k
where Tk represents the quantity of trait k in city j.
j

value for the quality of life.4 The prices repre­
sent the annual costs or benefits of a 1 percent
increase in the local trait (Table 1, p. 8.).
Estimating Prices. Among the local ameni­
ties, the percentage of sunny days and being
situated on a coast have the largest prices. The
4Gyourko and Tracy (1991) offer a detailed description
of how the city trait prices were estimated and how the
rankings were computed. The data used cover 130 cities
throughout the United States. Most of the variables, whose
names are self-explanatory, are for the years 1979-80. The
cost-of-living index is derived from the Bureau of Labor
Statistics' intermediate family budget adjusted to measure
the nonland cost of living.




results indicate that a 1 percent increase in the
amount of sunny days is worth almost $28 per
year. Of this amount, nearly $22 is paid in
terms of added housing expenditures and about
$6 is paid in terms of lower wages. The strong
influence of being near an ocean, major gulf, or
one of the Great Lakes is indicated by the high
positive price for the coast variable. The esti­
mates from Gyourko and Tracy show that being
on a coast was worth almost $1090 per year.
That is, an entrant to a coastal city was willing
to pay at least that much more per year in a
combination of higher land rents or lower wages.
Many of the tax and service measures are
7

MARCH/APRIL 1991

BUSINESS REVIEW

TABLE 1

Annual Trait Pricesab
City Trait

Full Price

Precipitation (annual inches)

-$1.22

(8.45)

Cooling degree days (thousands per year)

-8.86

(5.59)

Heating degree days (thousands per year)

-22.58

(8.49)

Average relative humidity (%)

-3.61

(22.95)

Sunshine (% of possible days)

27.87

(26.82)

Average wind speed (mph)

21.39

(13.64)

Particulate matter (micrograms per cubic meter)

-2.01

(7.15)

1089.86

(560.28)

Nonland cost-of-living index

-27.70

(115.55)

Violent crime rate (per 100 capita)

-12.40

(2.97)

Student/teacher ratio

-3.76

(10.33)

Fire department quality rating (1 = best; 10 = worst)

-3.55

(6.36)

Hospital beds (per 1000 capita)

11.85

(3.53)

Property tax rate

-6.14

(2.37)

State and local income tax rates

-5.36

(2.41)

State corporate tax rate

15.30

(4.91)

Percentage of public union organization

-2.89

(4.54)

SMSACpopulation (millions)

-0.30

(1.20)

3.49

(4.15)

Coast

Percentage of the labor force working in another SMSA

aThe calculations of trait prices are based on a 1 percent change about the mean of the variables.
The exception is the dichotomous COAST variable, whose prices are based on a discrete change from
noncoast to coastal status. All figures in these three columns are annualized. We assume 1.5 wage
earners per household and that each wage earner works 49 weeks. These are the sample averages.
bStandard errors of the implicit prices are in parentheses.
C
SMSA is the abbrevation for standard metropolitan statistical area.


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FEDERAL RESERVE BANK OF PHILADELPHIA

Joseph Gyourko

How Accurate A re Quality-of-Life Rankings Across Cities?

also quite influential. Consider violent crime
and tax rates on property and income. Clearly,
increases in the incidence of violent crime lower
the quality of life. All else constant, an entrant
to the average city in terms of crime would
require $12.40 in annual compensation if that
city were to experience a 1 percent increase in
the incidence of violent crime.5 As expected,
higher property or income tax rates have nega­
tive prices, if the service level is held constant.
If taxes are higher in some city, but the locality
provides no commensurate increase in service
provision, we would expect an entrant to the
area to demand compensation in terms of lower
land rents or higher wages.
Computing Index Values. Implicit prices
are used to compute quality-of-life index val­
ues by comparing each city to a hypothetical
city having the average values of all city traits.
The index, measured in 1979 dollars, reflects
the premium individuals are willing to pay to
live in any given city relative to a hypothetical
city with the average amenities and fiscal con­
ditions across all 130 cities in our sample.

5This is the same as saying that the entrant would pay a
negative $12.40 in the city with more crime. Hence, the
negative price.

Summary statistics illustrate the relative
effects of the local amenity and fiscal condi­
tions on the differences in quality of life across
cities (Table 2). The full range of quality-of-life
values based on all city traits is $8227. That is,
an entrant was willing to pay at least $8227
more per year to live in the top-ranked city
versus the bottom-ranked city. This band is
wide because of some extreme cities. For a
more representative view, let us focus on the
middle of the distribution and analyze what
statisticians call the interquartile range. The
interquartile range reveals how much more
per year an entrant is willing to pay to live in
the city ranked in the 25th percentile (rank 32
out of 130) versus the city ranked in the 75th
percentile (rank 97 out of 130). That range is
only $1484.
For the moment, let us consider the impact
of the 11 amenity values separately.6 All else

6The amenity variables include precipitation, cooling
degree days, heating degree days, relative humidity, sun­
shine, wind speed, particulate matter, coast, nonland cost of
living, SMSA population, and percent of population work­
ing in another SMSA. The tax/service variables include
violent crime rate, student/teacher ratio, fire department
quality, number of hospital beds, property tax rate, income
tax rates, and the corporate tax rate.

TABLE 2

Amenity and Fiscal Impacts on Quality-of-Life Rankings

Variable Set

Quality-of-Life
Range

Quality-of-Life
Interquartile Range

All city traits

$8227

$1484

Amenity component

$3979

$1372

Tax/service component

$6582

$1188




9

BUSINESS REVIEW

constant, one would pay $3979 more to live in
the top-amenity city than in the city with the
worst amenity set. There is a particularly wide
range for the impact of the seven tax/service
variables ($6582). However, looking only at
the middle of the distribution shows that the
fiscal characteristics have only a slightly less
strong effect than amenities on the differences
in quality of life across cities ($1188 versus
$1372)7 Even if the traditional amenity levels
were the same for all 130 cities, differences in
fiscal climate and public services would still
result in a difference of at least $1188 between
a city ranked in the 25th percentile and a city
ranked in the 75th percentile.
While readers undoubtedly will have quar­
rels with specific cities' relative positions in the
quality-of-life ranking, the overall rankings
accord with common sense (Table 3, p. 12).
Norwalk, CT, and Pensacola, FL, are the topranked cities. Stamford, CT, San Diego, CA,
and San Francisco, CA, also are in the top 20
percent. Newark, NJ, Detroit, MI, and Flint,
MI, are among the lowest-ranked cities.
Wilmington, DE, with a ranking of 31, is rated
just among the top 25 percent. Philadelphia,
PA, falls in the bottom half of the range, with a
ranking of 101.
A NOTE OF CAUTION
Previous quality-of-life studies end after
pronouncing the best and worst cities. Unfor­
tunately, the rankings are not reliable enough
to stop there. The underlying problem is that
the estimation of the trait prices is imprecise. If
there is estimation error in the trait prices,

7In the wage equation, the partial R2 for the fiscal vari­
ables was almost identical to the partial R2 for the amenity
variables. In the housing-expenditure equation, the partial
R2for the fiscal variables was about one-third as great as the
partial R2 for the amenity variables. Compared with the
amenity variables, then, the fiscal variables explain as much
of the variation in wages, but about one-third as much of the
variation in housing expenditures.


10


MARCH/APRIL 1991

there must also be estimation error in the quality-of-life index values, which are themselves
based on the trait prices.7 It turns out that we
8
can confidently differentiate among qualities
of life only when comparing the top-ranked
cities to the lowest-ranked cities.
For example, the estimation errors are so
large that we cannot confidently distinguish
between the rankings of cities such as Wilming­
ton (31), which is estimated to be in the top
quarter of the distribution, versus Charleston,
WV, which is ranked just below the middle of
the distribution (71). Given the estimation
error, there is about a two-thirds probability
that Charleston's ranking actually is anywhere
between 47 and 95. The analogous interval for
Wilmington is between 12 and 50.9 This inabil­
ity to confidently rank one city above another
holds true for most of the cities in the sample.
Statistically meaningful distinctions generally
can be made only between top-ranked and
bottom-ranked cities. For example, we can
confidently distinguish between any of the top20-ranked cities and the bottom-20-ranked cit­
ies.
CONCLUSION
What do these results mean for quality-oflife rankings? First, local fiscal conditions as

8The numbers in parentheses in Table 3 are the standard
errors of the index values or of the rankings themselves and
provide a measure of the imprecision of the underlying
estimation. The standard error is a widely used measure of
variability. Statistically, there is a two-thirds probability
that the ranking or index value is within one standard error
of its estimated value. While our estimate of Norwalk's
quality-of-life index number is $3986.26, the standard error
of $1135.10 implies a two-thirds probability that the true
index value is between $2851.16 and $5121.36 ($3986.26$1135.10).
9The standard error of Charleston's ranking is about 24
and that for Wilmington is about 19. Recall that this implies
a two-thirds probability that Charleston's ranking is be­
tween 71-24 (between 47 and 95) and that Wilmington's
ranking is between 31±19 (between 12 and 50).

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Joseph Gyourko

How A ccurate A re Quality-of-Life Rankings Across Cities?

well as amenities truly influence the attractive­
ness of localities. The most recent evidence
suggests that the effect of fiscal conditions on
the quality of life rankings is nearly as great as
the effect of natural locational advantages.
Moreover, the influences of these local traits on
the quality of life can be measured in terms of
their impact on local land and labor markets.

Finally, many other local traits influencing the
quality of life have not yet been captured, such
as cultural and recreational opportunities. It is
the omission of these traits that makes the
rankings so imprecise. Given current data and
estimation techniques, we simply cannot effec­
tively distinguish among most cities. To do so
requires much better data.

REFERENCES
Blomquist, Glenn, Mark Berger, and John Hoehn. "New Estimates of the Quality of Life in Urban
Areas," American Economic Review 78 (March 1988) pp. 89-107.
Gyourko, Joseph, and Joseph Tracy. "Local Public Sector Rent-Seeking and Its Impact on Local Land
Values," Regional Science and Urban Economics 19 (August 1989) pp. 493-515.
Gyourko, Joseph, and Joseph Tracy. "The Importance of Local Fiscal Conditions in Analyzing Local
Labor Markets," Journal of Political Economy 97 (October 1989) pp. 1208-31.
Gyourko, Joseph, and Joseph Tracy. "The Structure of Local Public Finance and the Quality of Life,"
Journal o f Political Economy (August 1991).
Linneman, Peter. "Hedonic Prices and Residential Location," in Douglas B. Diamond, Jr., and
George Tolley, eds., The Economics of Urban Amenities. New York: Academic Press, 1982.
Roback, Jennifer. "The Value of Local Urban Amenities: Theory and Measurement."
dissertation. University of Rochester, 1980.

Ph.D.

Roback, Jennifer. "Wages, Rents, and the Quality of Life," Journal of Political Economy 90 (December
1982) pp. 1257-79.
Rosen, Sherwin. "Hedonic Prices and Implicit Prices," Journal of Political Economy 82 (October 1974)
pp. 34-53.
Rosen, Sherwin. "Wage-based Indexes of Urban Quality of Life," in Peter Mieszkowski and Mahlon
Straszheim, eds., Current Issues in Urban Economics. Baltimore: Johns Hopkins University Press,
1979.
Voith, Richard. "Capitalization of Local and Regional Attributes Into Wages and Rents: Differences
Across Residential, Commercial, and Mixed-Use Communities," Journal of Regional Science
(Spring 1991).




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MARCH/APRIL 1991

BUSINESS REVIEW

TABLE 3

Quality-of-Life Index Values and Rankings
City3
Norwalk, CT
Pensacola, FL
Gainesville, FL
San Diego, CA
Stamford, CT
Columbia, SC
Santa Rosa, CA
Bridgeport, CT
Tucson, AZ
Shreveport, LA
Lancaster, PA
Modesto, CA
Asheville, NC
New Orleans, LA
Fall River, MA
Danbury, CT
Amarillo, TX
Jacksonville, FL
San Francisco, CA
San Jose, CA
New Britain, CT
Lake Charles, LA
New Bedford, MA


12


Ranking Index Vali
1
(4.1)b
2
(4.0)
3
(7.3)
4
(8.4)
5
(9.4)
6
(14.7)
7
(11.4)
8
(9.3)
9
(13.5)
10
(7.3)
11
(9.0)
12
(9.4)
13
(11.8)
14
(10.8)
15
(16.5)
16
(22.1)
17
(16.9)
18
(13.1)
19
(16.4)
20
(16.2)
21
(23.1)
22
(15.9)
23
(17.9)

3986
(1135)°
2963
(714)
2819
(890)
2574
(860)
2497
(875)
2459
(1137)
1955
(744)
1944
(630)
1822
(780)
1802
(473)
1784
(547)
1678
(550)
1577
(622)
1565
(570)
1549
(795)
1498
(1009)
1475
(795)
1463
(630)
1416
(796)
1403
(740)
1389
(1003)
1388
(725)
1316
(765)

City3
Tyler, TX
Odessa, TX
Erie, PA
Phoenix, AZ
Knoxville, TN
Lafayette, LA
Monroe, LA
Wilmington, DE
Waco, TX
Springfield, MO
Sacramento, CA
Lubbock, TX
Los Angeles, CA
Birmingham, AL
Jersey City, NJ
Fresno, CA
Roanoke, VA
Columbia, MO
El Paso, TX
Savannah, GA
Richmond, VA
Topeka, KS
Baton Rouge, LA

Ranking

Index Value

24
(14.6)
25
(17.1)
26
(18.4)
27
(26.5)
28
(10.7)
29
(15.2)
30
(11.1)
31
(19.2)
32
(21.4)
33
(11.8)
34
(18.0)
35
(20.3)
36
(15.1)
37
(25.8)
38
(29.7)
39
(24.6)
40
(16.7)
41
(22.5)
42
(25.8)
43
(20.8)
44
(20.4)
45
(14.4)
46
(18.9)

1175
(605)
1118
(671)
1103
(706)
1097
(1038)
1071
(412)
930
(548)
905
(404)
898
(666)
880
(745)
753
(386)
703
(564)
690
(650)
605
(930)
590
(823)
573
(984)
542
(773)
518
(490)
464
(667)
438
(787)
428
(600)
398
(575)
383
(392)
376
(540)

FEDERAL RESERVE BANK OF PHILADELPHIA

Joseph Gyourko

How A ccurate A re Quality-of-Life Rankings Across Cities?

City3
Albuquerque, NM
Memphis, TN
Orlando, FL
Fort Wayne, IN
Evansville, IN
Pittsburgh, PA
Fayetteville, NC
Mobile, AL
Wichita, KS
Lynchburg, VA
Worcester, MA
Austin, TX
Lawton, OK
San Antonio, TX
Waterbury, CT
Springfield, OH
Jackson, MS
Chattanooga, TN
St. Joseph, MO
Pueblo, CO
Manchester, NH
Terre Haute, IN
Bakersfield, CA
Macon, GA
Charleston, WV




Ranking Index Value
47
(23.4)
48
(20.2)
49
(20.0)
50
(16.1)
51
(16.5)
52
(27.4)
53
(19.8)
54
(24.7)
55
(17.7)
56
(16.3)
57
(21.6)
58
(23.7)
59
(21.0)
60
(25.7)
61
(24.1)
62
(14.1)
63
(18.7)
64
(18.9)
65
(17.9)
66
(21.0)
67
(26.5)
68
(15.4)
69
(27.6)
70
(16.9)
71
(23.5)

365
(673)
325
(576)
308
(545)
303
(437)
286
(455)
275
(846)
274
(543)
250
(712)
246
(474)
241
(439)
216
(599)
180
(666)
178
(578)
110
(740)
107
(684)
101
(363)
18
(504)
-41
(496)
-53
(479)
-89
(564)
-100
(765)
-112
(404)
-120
(807)
-140
(453)
-158
(647)

City3
Decatur, IL
Colorado Springs, CO
Lincoln, NE
Altoona, PA
Huntsville, AL
Anderson, IN
Oklahoma City, OK
Billings, MT
Syracuse, NY
Columbus, GA
Buffalo, NY
Canton, OH
Omaha, NE
Springfield, IL
Miami, FL
South Bend, IN
Salem, OR
Tulsa, OK
Portland, ME
Akron, OH
Harrisburg, PA
Cincinnati, OH
Cedar Rapids, IA
Indianapolis, IN
Reno, NV

Ranking

Index Value

72
(18.4)
73
(22.0)
74
(18.1)
75
(27.7)
76
(19.1)
77
(18.2)
78
(24.4)
79
(26.7)
80
(24.8)
81
(22.4)
82
(27.1)
83
(14.8)
84
(12.8)
85
(14.0)
86
(29.1)
87
(15.6)
88
(21.1)
89
(13.7)
90
(26.5)
91
(15.8)
92
(24.3)
93
(16.8)
94
(18.1)
95
(16.3)
96
(29.1)

-161
(495)
-165
(598)
-185
(470)
-187
(820)
-199
(519)
-234
(458)
-257
(694)
-285
(786)
-301
(707)
-305
(634)
-314
(806)
-340
(375)
-379
(337)
-409
(362)
-445
(925)
-468
(430)
-488
(604)
-496
(377)
-498
(812)
-520
(438)
-537
(724)
-544
(484)
-544
(529)
-600
(477)
-639
(977)

13

MARCH/APRIL 1991

BUSINESS REVIEW

City3
Sioux City, IA
Dayton, OH
Des Moines, IA
Trenton, NJ
Philadelphia, PA
Louisville, KY
Columbus, OH
Seattle, WA
Rochester, NY
Tacoma, WA
Mansfield, OH
Boise, ID
Toledo, OH
Boston, MA
Minneapolis, MN
Chicago, IL
Tuscaloosa, AL

Ranking Index Val
97
(17.9)
98
(18.2)
99
(14.0)
100
(21.7)
101
(20.7)
102
(13.3)
103
(11.6)
104
(25.1)
105
(20.8)
106
(21.7)
107
(20.4)
108
(13.6)
109
(12.9)

no
(18.3)
111
(20.8)
112
(17.3)
113
(13.7)

-675
(553)
-699
(532)
-700
(440)
-715
(679)
-736
(813)
-794
(429)
-811
(384)
-816
(848)
-842
(671)
-846
(723)
-965
(710)
-972
(486)
-1013
(479)
-1067
(703)
-1147
(816)
-1209
(1031)
-1259
(584)

City3
Muncie, IN
Ann Arbor, MI
Cleveland, OH
Rockford, IL
Peoria, IL
Spokane, WA
Portland, OR
Kansas City, MO
Atlanta, GA
Hartford, CT
Baltimore, MD
Newark, NJ
Las Vegas, NV
Grand Rapids, MI
Saginaw, MI
Detroit, MI
Flint, MI

Ranking Index Val
114
(12.9)
115
(14.9)
116
(10.9)
117
(7.0)
118
(6.5)
119
(11.6)
120
(8.7)
121
(5.4)
122
(9.7)
123
(13.9)
124
(9.4)
125
(9.8)
126
(9.0)
127
(2.6)
128
(1.4)
129
(1.1)
130
(1.2)

-1373
(595)
-1450
(697)
-1492
(560)
-1532
(399)
-1634
(411)
-1815
(728)
-1874
(607)
-1900
(441)
-1916
(671)
-1931
(871)
-1934
(662)
-2477
(914)
-2832
(1027)
-2947
(589)
-3668
(646)
-4153
(751)
-4241
(786)

aCertain cities, such as New York and St. Louis, were not included in the analysis because of lack of data.
b
The numbers in parentheses in column 2 are estimated standard errors, which were calculated using a sample
of 100,000 simulated rankings. Housing and wage coefficient vectors were drawn from the relevant normal
distributions implied by the appropriate regression analysis. Full implicit prices and associated quality-of-life
rankings were calculated for each set of simulated coefficient vectors. The reported standard error for a city ranking
is the standard deviation in the sample of the given city's simulated rankings.
T h e numbers in parentheses in column 3 are estimated standard errors of the index values.


14


FEDERAL RESERVE BANK OF PHILADELPHIA







Activist Monetary Policy
for Good or Evil?
The New Keynesians vs. the New Classicals

F

J L J conomic analysts and policy practitio­
ners argue endlessly about how long it takes
for monetary policy actions to affect output or
employment, how long the effects will last, or
how large they will be. But underneath it all,
the truth is that economists cannot agree on

*Tom Stark, Research Associate, and Herb Taylor, Assis­
tant Vice-President and chief of the Macroeconomics Sec­
tion, both work in the Research Department of the Federal
Reserve Bank of Philadelphia.




Tom Stark and Herb Taylor*
how monetary policy affects the real economy
in the first place. Theoreticians are offering
two different explanations, each with its own
implications for the way monetary policy ought
to be conducted.
Perhaps the most popular explanation for
money's impact was first proposed about 15
years ago by a group of economists now known
as the New Classicals. These economists see
episodes of money affecting economic activity
as temporary aberrations that occur only when
monetary policy actions happen to catch the
17

MARCH/APRIL 1991

BUSINESS REVIEW

public by surprise. Because they see these
episodes as harmful, the New Classical econo­
mists think that central banks should avoid
such surprises. They think that a central bank
should just announce a simple money growth
plan and stick to it. Such a policy, they say,
would minimize economic disruptions and make
inflation predictable.
In the last few years a group of economists
labeled the New Keynesians has begun mount­
ing a challenge to the
New Classical view.
The New Keynesians
claim that under the
right circumstances
even widely publi­
cized monetary pol­
icy actions can have a
sustained impact on
output and employ­
ment. And they claim
that this impact can
be used to help counteract what they see as the
economy's tendencies toward excessive vola­
tility and unemployment. So the New Keynes­
ians think that a good central bank conducts an
activist monetary policy—it actively manages
the supply of money and credit to keep the
economy close to full employment.
Which side is right? Is an activist monetary
policy good or evil? Neither side has all the
answers, but both command serious attention
in a very important policy debate.

resources—its labor, raw materials, factories,
and equipment—fully and efficiently. Activist
monetary policy has no place in this world.
Policy actions designed to alter the pattern of
economic activity are ineffective and unneces­
sary.
Competition among many small households
and firms makes the Classical economy effi­
cient. In the Classical system, overall supply
and demand conditions determine the prices
people pay and the
wages they earn. No
business or individ­
ual is big enough to
manipulate market
conditions to its own
advantage. Any firm
that tried to charge
above-market prices
for its product would
lose all of its custom­
ers to competing pro­
ducers. Any worker that held out for above­
market wages would lose his or her job to
competing workers.
This environment may sound harsh, but it
gives firms the incentive to perform at peak
efficiency. Given the wage-price structure,
each firm faces just one basic decision: how
much to produce. And in its quest for profits,
the firm will automatically choose a produc­
tion level that balances consumer preferences
with resource availability.
Consider the typical firm. For each unit it
produces, it gets the market price. It also incurs
costs equal to the price of the requisite labor
and materials. The more it produces, the more
it is prone to operating inefficiencies that push
up per-unit production costs. At some point,
the cost of producing another unit would ex­
ceed the product's market price. Expansion
beyond that point would cut into profits, so the
firm expands no further. Following this strat­
egy not only maximizes the firm's own profits,
it promotes overall economic efficiency as well.

The New Classicals:
Monetary policy might
affect economic
activity, but don’t
count on it.

THE NEW CLASSICALS' CASE
AGAINST ACTIVIST POLICY
Like the great Classical economists of the
last century, the New Classicals see the market
system naturally bringing the economy to its
peak level of efficiency. They see markets as a
network of competitive auctions in which prices
respond quickly and completely to changes in
economic conditions. Basing their decisions on
these market prices, households and firms
automatically deploy the economy's real

18


FEDERAL RESERVE BANK OF PHILADELPHIA

Activist M onetary Policy fo r Good or Evil?

The product's market price measures its worth
to the consumer. Wages and other input prices
measure workers' and resource suppliers' valu­
ation of their time and materials. So, in effect,
the firm is producing only the units whose
benefits to the consumer justify the burden
their production imposes on workers and other
resources.
Of course, economic conditions are con­
stantly changing. Consumers' preferences shift
away from one product and toward another; a
new production technology comes along and
displaces an old one. But in the Classical view,
market prices and wages adjust quickly to
changes in supply and demand, providing firms
with the incentives to keep the economy's re­
sources fully and efficiently employed. With
the market system allocating resources so ef­
fectively, there is no reason to use monetary
policy to alter the level of economic activity.
But it's just as well. Because in the Classical
world, any attempt at activist policy would
fail.
The Classical economists developed the
theory that money has no effect on economic
activity. Clearly, prices are crucial to people's
economic decisions in the Classical system.
And usually we think of prices being quoted in
terms of money. Yet the Classical economists
maintained that changing the money supply
would have no impact on output or employ­
ment. How can this be?
The Classicals claimed that when the money
supply changed, all prices and wages would
change in equal proportion, leaving the rela­
tionships among them unchanged. Conse­
quently, households and firms would stick by
their original employment and production
decisions, leaving the real economy unaffected.1

aTo see this, suppose that initially bread costs $1 and
workers earn $6 an hour, making a loaf of bread worth 10
minutes' work. If both prices and wages double, bread goes
to $2 and wages go to $12, but a loaf of bread still trades for
10 minutes' work.




Tom Stark and Herb Taylor

Suppose, for instance, that the central bank
pumps up the money supply. This increases
the overall demand for goods and services,
pushing up market prices. But workers recog­
nize that higher prices erode the purchasing
power of their wages. So they are willing to
work the same hours and expend the same
effort only if they get wage increases commen­
surate with the increase in market prices. Firms,
competing for workers, agree to pay for the
raises out of their inflated sales revenues, and
they maintain their original level of employ­
ment and output. All that remains of the
money supply increase are higher prices and
wages.
The Classical economists recognized that, as
a practical matter, these adjustments to a change
in the money supply would not always pro­
ceed as smoothly as their theoretical analysis
might suggest. But their message comes through
clearly enough: the money supply ultimately
affects the level of prices, not the level of eco­
nomic activity.
The New Classical economists reinvigor­
ated the Classical argument that monetary policy
is generally ineffective. The Classical perspec­
tive on money's role in the economy was among
the casualties of the Great Depression. The
Keynesian Revolution swept through the eco­
nomics profession and gave birth to the activist
monetary policies of the postwar period. But
in the early 1970s, some economists resurrected
the Classical viewpoint. In fact, by combining
parts of the Classical tradition with the notion
of "rational expectations," these New Classical
economists emerged with an even stronger
position: monetary policy cannot systemati­
cally affect the real economy. Instances in
which monetary policy actions alter employ­
ment or output levels are occasional, random
events.
The New Classical analysis of money's impact
on the economy is a variation on the old adage
"knowledge is power." In keeping with their
Classical tradition, the New Classicals main­
19

BUSINESS REVIEW

tain that markets are competitive enough to
drive the economy to full employment, and
responsive enough to keep it there in the face of
shifting economic conditions. To this they
simply add that a key element in markets'
responsiveness is market participants acting
upon rational expectations about where the
economy is headed. The New Classicals as­
sume that market participants understand the
underlying structure of the economy and use
the available data on current economic condi­
tions to formulate accurate forecasts about future
economic performance. Presumably, partici­
pants' actions in the marketplace today reflect
those rational expectations.
The New Classicals go on to argue that
market participants pretty much know what to
expect from the monetary authority. Competi­
tive market prices and wages automatically
reflect those expectations, thus neutralizing
the impact of any anticipated policy actions on
output and employment. Admittedly, policy
actions that take people by surprise can affect
economic activity. But, the New Classicals
point out, such "surprises" must, by definition,
be occasional and without pattern. So the
monetary authority cannot systematically in­
fluence the level of output or employment.
The New Classicals emphasize that even
when a monetary policy action does take people
by surprise, its impact is temporary. It lasts
only as long as it takes for the markets to find
out what the central bank has done and re­
spond. And in the interim, people—particularly
workers—are not necessarily better off.2
Textbook versions of the New Classical view
assume that product prices respond to sudden

2Thomas Sargent and Neil Wallace, in their article " 'Ra­
tional' Expectations, the Optimal Monetary Instrument and
the Optimal Money Supply Rule," Journal of Political Econ­
omy (April 1975) pp. 241-54, present a clear statement of the
New Classical notion that expected monetary policy actions
have no effect on economic activity.


http://fraser.stlouisfed.org/
20
Federal Reserve Bank of St. Louis

MARCH/APRIL 1991

shifts in economic conditions more quickly
than wages do. For one thing, wage agree­
ments, whether formal or informal, may cover
several months, a year, or even several years—all
periods much longer than it takes for product
prices to change. Even where wages are set
more frequently, workers usually agree to a
certain wage without the benefit of complete
information on the prices of the products they
intend to buy. Consequently, when an unex­
pected monetary expansion comes along and
pushes up product prices, firms find they can
retain, and perhaps even expand, their work
force without raising wages very much. And
they make the most of the opportunity. They
pay a slightly higher wage, hire more workers,
produce more output, and sell it at the new,
higher prices. Hence the expansionary mone­
tary policy boosts aggregate employment and
output.3
Of course, the workers eventually catch on.
They shop. They see the higher product prices.
And the next time they negotiate a wage, they
demand compensation for their loss in pur­
chasing power. Once wages rise as much as
prices have, firms revert to their original hiring
and production patterns. So money is, in the
last analysis, neutral.
Overall, the New Classical analysis of money's
impact on the economy casts activist monetary
policy in a very dim light. First of all, the New
Classicals see the economy exhibiting a strong

3Analyses stressing the role of wage contracts in limiting
short-run wage flexibility can be found in Stanley Fischer's
"Long-Term Contracts, Rational Expectations, and the
Optimal Money Supply Rule," Journal of Political Economy
(February 1977) pp. 191-205, and John Taylor's "Aggregate
Dynamics and Staggered Contracts," Journal of Political
Economy (1980) pp. 1-24. The idea that wages adjust imper­
fectly because workers are not completely aware of current
product prices is more consistent with the original New
Classical formulation by Robert Lucas in "Some Interna­
tional Evidence on Output-Inflation Tradeoffs," American
Economic Review (June 1973) pp. 326-34.

FEDERAL RESERVE BANK OF PHILADELPHIA

Activist Monetary Policy for Good or Evil?

tendency toward full employment that makes
it unnecessary for the monetary authority to
focus on the level of economic activity. But
even beyond that, attempts to conduct an ac­
tivist policy do more harm than good. An
expansionary policy anticipated by the public
simply creates instant inflation. If, as occasion­
ally happens, the policy is not anticipated by
the public, it affects output and employment
essentially by tricking people into producing at
a pace they would not have chosen if they were
fully informed.
Given this perspective, the New Classicals'
advice to policymakers is straightforward: do
not try any surprise moves. Choose a simple
money growth plan consistent with your infla­
tion goals. Announce the plan far enough in
advance to allow markets to react. Then just
follow the plan.4
THE NEW KEYNESIANS’ CASE
FOR AN ACTIVIST POLICY
The New Keynesians don't see things quite
the way the New Classicals do. The New
Keynesians see an economy in which firms face
only limited compe­
tition. These imper­
fectly com petitive
firms restrict their
output to keep prices
high and respond
only partially to shift­
ing demand condi­
tions. As a result, the
economy shows the
tendencies toward
u nd erem ploym ent
and price "stickiness" that are very much a part
of the traditional Keynesian perspective. The

Tom Stark and Herb Taylor

New Keynesians believe that in this world,
regardless of how people form their expecta­
tions, monetary policy can and should be used
to expand the level of economic activity.
Without strict market discipline, firms are
less likely to achieve maximum economic effi­
ciency. The difference between the Classical
competitive firm and the imperfectly competi­
tive firm is simple: the competitive firm must
take the market price of its product as a given,
whereas the imperfect competitor has the power
to set price to its own advantage. And the right
price structure for the imperfect competitor is
not necessarily best for the overall economy.
In the competitive market, each firm is small
and its output is nothing special. So its decision
about how much to supply has no appreciable
impact on the market price. If Farmer Jones
decided to withhold some of his wheat from
the market, how far could he drive up the price
of wheat? If he tried to charge extra for Farmer
Jones Wheat, who would pay the premium?
No one.
Imperfect competitors have larger opera­
tions. Their product may have some special
characteristic—real
or imagined— that
differentiates it in the
mind of consumers.
For these firms, size
or special niche gives
them some power
over the price of thenproducts. If General
Mills were willing to
cut its supply of
breakfast cereal, ce­
real prices would rise. And if it decides to
increase the price of Wheaties®, some people
would be willing to pay the premium.
In short, the imperfectly competitive firm
has some advantage that frees its pricing struc­
ture from the strict discipline of the market. Of
course, the firm is still subject to the Law of
Demand: the higher the price it sets, the fewer

The New Keynesians:
Monetary policy
can and should
be used
to affect real activity.

4The New Classical argument for this approach to
monetary policy has most recently been articulated by
Bennett McCallum in Monetary Economics: Theory and Policy
(Macmillan, 1989).




21

BUSINESS REVIEW

units it will sell. So it must choose between
setting a high price and selling to a limited
number of customers, or setting a low price
and grabbing the lion's share of the market.
But one thing is for sure: it will not set as low a
price as a Classical competitive market would
establish. It will always find it profitable to set
a higher price and maintain it by keeping out­
put below competitive levels.
Exercising market power may make indi­
vidual firms more profitable, but it imposes
costs on society as a whole. From the social
standpoint, imperfect competitors' prices are
too high and their production is too low. Soci­
ety would be better off if these firms would cut
their prices to levels more consistent with re­
source costs. This would expand sales, pro­
duction, and employment to more socially
desirable levels.
Neither the notion of imperfect competition
nor its impact on social welfare are original to
the New Keynesians.5 But the analysis offers
them a rationale for their belief that the econ­
omy tends to underemployment. And it offers
them something more— a jumping-off point
for a new theory of how monetary policy can
help alleviate the problem.
The New Keynesians believe monetary pol­
icy can work on imperfect competitors. Tradi­
tional theories of imperfect competition can
explain underemployment, but they cannot
explain why monetary policy should be effec­
tive in combating it. As long as prices and
wages respond flexibly, the monetary author­
ity is still powerless to affect firms' output and
employment decisions. But the New Keynes­
ians add a new wrinkle to the theory of imper­
fect competition: imperfectly competitive firms'

5The term "imperfect competition" is used here as a con­
venient expression for "monopolistic competition," a mar­
ket model that can be traced back to the work of E.H. Cham­
berlin in the 1930s. Texts such as Paul Samuelson's Econom­
ics (McGraw-Hill) provide readable discussions of this
market type.


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MARCH/APRIL 1991

prices are not as flexible as competitively estab­
lished market prices. So real activity may
respond to monetary policy actions.
In the Classical world, competitive markets
adjust prices quickly and completely to every
shift in economic conditions. In a world of
imperfect competition, firms must set prices.
When demand shifts are relatively small, these
firms may not find changing prices worth­
while. It may be more profitable to maintain
current prices and adjust production accord­
ingly.
Economists have labeled the costs firms bear
when they change their product prices "menu
costs." That name captures the most obvious
cost of repricing: printing new menus and cata­
logs and changing price tags and signs. But
there are other costs as well. To find the new
profit-maximizing price, the firm must esti­
mate the likely nature, magnitude, and dura­
tion of the shift in customer demand. That kind
of research and analysis uses up resources. In
addition, frequent price changes may alienate
customers and cost the firm some of its good
will.
It's difficult to say how large menu costs are.
It may seem that, as a practical matter, the cost
of changing prices ought to be relatively small.
But the New Keynesians emphasize that the
benefits to changing prices can be small for
imperfect competitors, too. So even small menu
costs can thwart a price change.
When the demand for an imperfect competi­
tor's product increases, the firm can respond in
any number of ways. At one extreme, it can
take the opportunity to raise its prices without
losing sales. At the other extreme, it can hold
the line on prices and take the opportunity to
pick up sales volume. If the demand shift that
the firm is experiencing is large, then choosing
the right strategy can have a substantial impact
on profits. But if the demand shift is relatively
small, there is little advantage to choosing one
over the other. A firm that simply maintains its
original prices will not get as much as it could
FEDERAL RESERVE BANK OF PHILADELPHIA

Activist Monetary Policy for Good or Evil?

on each unit, but it will sell more units. So its
profits will not be substantially compromised.6
Once menu costs—even small ones—enter the
equation, they can tip the scales in favor of
maintaining current prices. Thus the profitmaximizing imperfect competitor may choose
to accommodate a small demand shift without
changing the price of its product.
This tendency for prices to be sticky in an
imperfectly competitive environment affords
the central bank some opportunity to influence
overall output and employment. Suppose the
central bank increases the money supply and
thereby boosts overall demand for goods and
services. Further suppose that individual firms
decide that the demand increase is too small to
make a price adjustment profitable. Instead,
they decide to hold the line on prices and fully
accommodate the increased demand for their
products. In order to increase their output,
they begin to hire more workers. So both
output and employment pick up. Meanwhile,
since product prices are not rising, workers are
not demanding an inflation adjustment to their
wages, so both wages and prices remain rela­
tively constant.7
The New Keynesians recognize that the central
bank's ability to raise output and employment

6This idea is sometimes called the PAYM insight be­
cause it emerged from the work of economists Michael
Parkin, George Akerlof, Janet Yellen, and N. Gregory
Mankiw. Specific references are to Parkin's "The OutputInflation Tradeoff When Prices Are Costly to Change," Jour­
nal of Political Economy (1986) pp. 200-24; Akerlof and
Yellen's "Can Small Deviations From Rationality Make Sig­
nificant Differences to Economic Equilibria?" American
Economic Review (September 1985) pp. 708-21; and
Mankiw's " Small Menu Costs and Large Business Cycles: A
Macroeconomic Model of Monopoly," Quarterly Journal of
Economics (May 1985) pp. 529-37.
701ivier Blanchard and Nobuhiro Kiyotaki develop this
argument formally in "Monopolistic Competition and the
Effects of Aggregate Demand," American Economic Review
(September 1987) pp. 647-66.




Tom Stark and Herb Taylor

in this way is circumscribed. If monetary pol­
icy actions create too large a demand shift,
firms are more likely to raise prices than in­
crease output. Furthermore, every firm faces
different demand conditions and menu costs.
Some will have lower thresholds for changing
prices than others. So almost any policy action
is likely to affect aggregate prices as well as
aggregate output. In short, the New Keynes­
ians acknowledge that a central bank cannot
engineer dramatic or persistent increases in
output and employment without driving up
prices and wages. Nonetheless, New Keynes­
ian analysis suggests that an activist policy can
be successful, if used judiciously.
Overall, the New Keynesians see the poten­
tial for an activist monetary policy to improve
the performance of an imperfectly competitive
economy. Monetary policy may not be a cureall, but it can help offset what New Keynesians
see as the economy's chronic bias toward
underproduction and underemployment in
modern, imperfectly competitive economies.
Add to this underlying bias the fact that the
economy is subject to sudden shifts in overall
demand, and the New Keynesians' case for an
activist monetary policy seems even stronger.
For if price stickiness accentuates the impact of
monetary policy on economic activity, it also
accentuates the impact of other demand shifts
as well. Thus a sudden decline in overall
demand could drop the economy well below
its potential level of performance. This sug­
gests that monetary policymakers should be
alert to these shifts and stand ready to offset
them.8
*
WHO'S RIGHT?
Both the New Classical and the New Keynes-

8Prospects for this kind of policy get some theoretical
support in Lars Svensson's "Sticky Goods Prices, Flexible
Asset Prices, Monopolistic Competition, and Monetary
Policy," Review of Economic Studies (1986) pp. 385-405.

23

B U S IN E SS R EV IEW

ians offer explanations for monetary policy's
impact on the economy. But the New Keynes­
ian approach certainly casts activist monetary
policy in a more positive light. Which explana­
tion should we believe? One way to evaluate
competing theories is to "let the data decide."
But at this point, empirical tests do not provide
a clear answer.
The New Classical theory has been around
longer and been subjected to more empirical
study. The results are not favorable to the
hard-line New Classical view that only unex­
pected policy actions affect real activity. Statis­
tical analyses seem to show output and em­
ployment responding to anticipated policy
actions too. But, ironically enough, these kinds
of results have prompted some New Classicals
to support a theory that attributes even less
potency to monetary policy actions: the real
business cycle theory. According to this theory,
monetary policy never causes fluctuations in
economic activity. Rather, anticipated fluctua­
tions in the economy cause the public to in­
crease or decrease their demand for money.
The central bank and the financial system sim­
ply accommodate these demand fluctuations.9
The New Keynesian theory is relatively new,
and empirical evidence is scantier. There is
some supportive evidence, however. In coun­
tries where inflation is relatively low, which
would suggest that expansionary monetary
policies have not been pursued too aggres­
sively, policy shifts seem to have more impact
on real activity— as the New Keynesians would
predict. But tests of the New Keynesian model
are really in too early a stage to provide a

9Frederic Mishkin provides a more complete discussion
of the evidence on the New Classical hypothesis in A Ra­
tional Expectations Approach to Macroeconometrics (Univer­
sity of Chicago Press, 1983). For a good discussion of the real
business cycle view and its monetary policy implications,
see "Monetary Policy with a New View of Potential GNP,"
by John Boschen and Leonard Mills, this Business Review
(June/July 1990) pp. 3-10.


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M A R C H /A PRIL 1991

convincing case one way or another.1
0
Empirical issues aside, there are unsettling
aspects to both the New Classical and the New
Keynesian models. Perhaps the most unset­
tling theoretical aspects have to do with the
functioning of the labor market. Both groups
admit they have trouble explaining why mone­
tary policy actions that affect output have such
a large effect on employment and such a small
effect on wages. According to the New Clas­
sical theory, an unexpected increase in product
demand induces firms to produce more be­
cause it pushes the product price up before
wages have had a chance to rise in response.
But firms need more workers in order to ex­
pand production. Won't that increased de­
mand for labor itself push up wages?
The New Classicals' answer: some, but not
much. True to their Classical perspective, they
maintain that labor markets are competitive.
They simply assume that labor supply is very
sensitive to wage changes. Thus when labor
demand increases, it evokes many more hours
of work at only a slightly higher wage. The
problem is that, as a practical matter, willing­
ness to work does not seem to be all that
sensitive to wage changes.
New Keynesians face a similar conundrum.
According to them, when firms face a small
increase in product demand, they hold the line
on prices and expand output. Again, to ex­
pand output, firms need more workers. Granted,
product prices are not increasing, so there is no
inflation pressure on wages. But won't firms
have to raise the wage they pay in order to

10This New Keynesian result is presented by Laurence
Ball, N. Gregory Mankiw, and David Romer in "The New
Keynesian Economics and the Output-Inflation Trade-Off,"
Brookings Papers on Economic Activity (1988:1) pp. 1-65. For
an up-to-date discussion of the empirical evidence on the
New Keynesian economics, as well as a good evaluation of
its theoretical underpinnings, see Robert Gordon, "What Is
New Keynesian Economics?" Journal of Economic Literature
(September 1990) pp. 1115-71.

FED ERA L R ESER V E BA N K O F PH ILA D ELPH IA

Activist M onetary Policy fo r Good or Evil?

induce more people to work? The New Keynes­
ians' answer is no. True to the Keynesian
tradition, they claim that there is a pool of
involuntarily unemployed workers from which
firms can always draw workers at the going
wage. But to explain the involuntary unem­
ployment, they must resort to some unconven­
tional theories of the labor market.
Imperfectly competitive firms charge high
prices, which restricts both output and em­
ployment. Nonetheless, the New Keynesians
claim, these firms tend to pay the people they
do employ relatively high wages. Different
economists offer different reasons for this ten­
dency. Proponents of the "efficiency wage"
theory emphasize thatby paying workers more
than they would expect to earn if they had to go
look elsewhere for a new job, the firm gives the
worker the incentive to perform more effec­
tively. Proponents of the "insider/outsider"
theory emphasize that employees whose expe­
rience on the job is valuable to the firm can
exact wage concessions from the firm. In either
case, with wages high and employment oppor­
tunities limited, there is routinely a pool of
willing workers unable to get jobs. Whenever
firms want to expand output, they can tap this
pool for workers without increasing the wage
they pay.1
1
In short, both the New Classicals and the
New Keynesians have a long way to go before
either can proclaim their approach to be theo­
retically complete.




om Stark and Herb Taylor

THE ACTIVIST
POLICY DEBATE RENEWED
When the New Classical economics came on
the scene in the early 1970s, it jolted academic
economists and policymakers as well. The
New Classicals were trying to explain pre­
cisely why monetary policy actions affect real
activity. They concluded that money tempo­
rarily affects output and employment by trick­
ing people into deviating from their preferred
activity levels. This conclusion hardly cast
activist monetary policy in the most favorable
light, but there was little theoreticians could
offer in rebuttal.
Now the New Keynesian school is offering
an alternative explanation for money's impact
on economic activity. That analysis, based on
theories of imperfect competition, looks more
favorably on activist monetary policy. The
New Keynesians conclude that the economy
tends toward underemployment and that an
activist policy can help overcome the problem.
The New Keynesians can hardly claim to
have overcome the New Classical paradigm.
But they have reinvigorated the battle over the
efficacy of an activist monetary policy.

11Lawrence Katz provides an excellent overview of
these modern labor market theories in "Some Recent Devel­
opments in Labor Economics and Their Implications for
Macroeconomics," Journal of Money, Credit, and Banking
(August 1988, Part 2) pp. 507-30.

25

d

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