Monetary Policy

Monetary policy is not easy. Central bankers have multiple objectives and, over time, must confront a variety of economic circumstances. They know their actions have powerful effects on the economy, but the timing, magnitude, and channels of those effects are not fully understood. Their job is made all the more difficult by widespread disagreements amount economists. Some economist view monetary policy as a potential cure for economic fluctuations. Other would be satisfied if monetary policy could avoid being a cause of fluctuations.

monetary economics investigates the relationship between real economic variables at the aggregate level – such as real output, real rates of interest, employment, and real exchange rates – and nominal variables – such as the inflation rates, nominal interest rates, nominal exchange rates, and the supply of money. So defined, monetary economics has considerable overlap with macroeconomics more generally, and these two fields have, to a large degree, shared a common history over most of the past 50 years.

This statement was particularly true during the 1970s after the monetarist / Keynesian debates led to a reintegration of monetary economics with macroeconomics. The seminal work of Robert Lucas(1972) provided theoretical foundations for models of economic fluctuations in which money was the fundamental driving factor behind movements in real output. The rise of real-business cycle models during the 1980s and early 1990s, building on the contribution of Kydland and Prescott (1982) and focusing explicitly on nonmonetary factors as the driving forces behind cycles, tended to separate monetary economics from macroeconomic.

More recently, the real-business-cycle approach to aggregate modeling has been used to incorporate monetary factors into dynamic general equilibrium models. Today, both macroeconomics and monetary economics share the common tools associated with dynamic, stochastic approaches to modeling the aggregate economy. Monetary policy today is dominated by three alternative modeling strategies. The first two, representative-agent models and overlapping-generations models, share a common methodological approach in building equilibrium relationships explicitly on the foundations of optimizing behavior by individual agents.

The third approach is based on sets of equilibrium relationships that are often not derived directly from any decision problem. Instead, they are described as ad hoc by critics and as convenient approximations by proponents. The latter characterization is generally more appropriate and these models have demonstrated great value in helping economist understand issues in monetary economics. It is widely agreed that the goals of monetary policy are a low rate of inflation (“Price stability”) and a small gap between actual real GDP and potential real GDP.

There is general agreement that a low long-term rate of inflation can be achieved by sufficiently limiting the rate of growth of a broad monetary aggregate over a long enough period of time. All the monetary policy rules that we consider are compatible with achieving any particular long run averate rate of inflation. Technically, we are assuming that the federal reserve could set the long-run inflation rate by the indentity that mean inflation equals mean money growth plus mean velocity growth less mean real output growth. Empirical evidence suggests that the long-run mean of the growth of M2 velocity is zero.