This paper discusses a simulation procedure where innovations from time-series processes are used in conducting simulation experiments with macroeconometric models. A particular theoretical example using the term structure of interest rates is studied here, along with actual simulation experiments using a large macroeconometric model. This analysis illustrates the advantages of simulating with innovations and the extent to which more standard simulation procedures lead to misleading results. The innovation-simulation technique can be used to provide information on the response of the economy to shocks, even when the macroeconometric model is not invariant to policy changes. Policymakers might find such information to be quite valuable.

[This paper discusses a simulation procedure where innovations from time-series processes are used in conducting simulation experiments with macroeconometric models. A particular theoretical example using the term structure of interest rates is studied here, along with actual simulation experiments using a large macroeconometric model. This analysis illustrates the advantages of simulating with innovations and the extent to which more standard simulation procedures lead to misleading results. The innovation-simulation technique can be used to provide information on the response of the economy to shocks, even when the macroeconometric model is not invariant to policy changes. Policymakers might find such information to be quite valuable.]

A heated debate has arisen over the policy ineffectiveness proposition associate with the work of Lucas, Sargent, and Wallace. It postulates that anticipated aggregate demand policy will have no effect on business-cycle fluctuations, so that one deterministic, feedback policy rule is as good as any other from the point of view of stabilizing the economy. This paper develops a methodology for empirically analyzing rational-expectations models displaying this neutrality result and then applies it to the important question of whether anticipated monetary policy matters to the business cycle.