Interest and Prices: Foundations of a Theory of Monetary Policy

Abstract

The evolution of research on monetary policy over the past two decades has been dramatic. The 1980's through the mid-1990's were dominated by work building on the insights of Kydland and Prescott, employing the notion of dynamic consistency to offer a theory of monetary policy, one in which discretionary policy by central banks led to socially costly inflation. Researchers studied the nature of the time inconsistency of monetary policy and developed solutions, ranging from appointing conservatives, to developing incentive contracts, to imposing inflation targets. Whether central bankers learned, in the words of Ben McCallum, to "just do it," or the nature of the incentives they faced changed, inflation was reduced in the industrialized economies during the 1980's and early 1990's. In the low-inflation environment since, central banks have, in the eyes of many monetary economists, changed from a source of (often) politically induced inflation to maximizers of social welfare. This shift has opened new and productive collaborations between academic economists and central bank economists interested in issues of monetary policy design. Much of this work builds on the basic foundations provided by the marriage of dynamic stochastic general equilibrium models, with their emphasis on optimizing behavior by economic agents and careful attention to budget constraints and equilibrium conditions, with simple models of price stickiness. Early contributors to these foundations include Yun (1996), Goodfriend and King (1997), and Rotemberg and Woodford (1997). The resulting framework for macroeconomic analysis, in its simplest form, boils down to an expectational IS curve, an inflation adjustment equation, and a specification of monetary policy in terms of either an objective function or a rule for setting the nominal rate of interest.

Output Gaps and Robust Monetary Policy Rules

“…6 The value assigned to i preserves the ratio i = x . The ratio is roughly 26 in Woodford (2003) 9 re ‡ect information available with the bene…t of hindsight. The di¤erence between the revised and real-time estimates represents historical revisions, which are described quite well with a standard, …rst-order autoregressive process.…”

Divergent Emerging Market Economy Responses to Global and Domestic Monetary Policy Shocks

“…We look into the factors behind the differences. There are a few welfare approximations in terms of key macroeconomic variables, basically extending the approximation for a closed economy proposed by Stock prices EME's policy rate US federal funds rate Woodford (2003). These are usually called loss functions, which are deemed as the objective function of policy authorities.…”

“…Of course, this argument depends on the weights placed on inflation and output gap in the loss function. For an open economy, Woodford (2003) makes the relative weights between output gap and inflation the same as for a closed economy, although inflation in the loss function usually stands for inflation of domestic goods (Corsetti, Dedola, and Leduc 2010). A typical calibration of parameters results in a low weight on the output gap.…”

Real Rigidities and the Cross-Sectional Distribution of Price Stickiness: Evidence from Micro and Macro Data Combined

“…-and . 37 We start with the case of strategic neutrality in price setting ( = 1). Then, new prices are set according to:…”