Optimal Monetary Policy under Uncertainty

Optimal Monetary Policy under Uncertainty

Richard T. Froyen and Alfred V. Guender

Recently there has been a resurgence of interest in the study of optimal monetary policy under uncertainty. This book provides a thorough survey of the literature that has resulted from this renewed interest. The authors ground recent contributions on the ‘science of monetary policy’ in the literature of the 1970s, which viewed optimal monetary policy as primarily a question of the best use of information, and studies in the 1980s that gave primacy to time inconsistency problems. This broad focus leads to a better understanding of current issues such as discretion versus commitment, target versus instrument rules, and the merits of delegation of policy authority.

Chapter 1: Introduction, Part I

Richard T. Froyen and Alfred V. Guender

Extract

1. Introduction, Part 1 J.M. Keynes The inevitable never happens. It is the unexpected always. Alan Greenspan began a speech by saying that “Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape” (2003, p. 1). He went on to say that “As a consequence, the conduct of monetary policy in the United States at its core involves crucial elements of risk management, a process that requires an understanding of the many sources of risk and uncertainty that policymakers face” (p. 1). More than 20 years earlier Henry Wallich (1980), explaining the Federal Reserve policy shift of October 1979, wrote that “Policymakers must take into account at all times the fact that both the economy and the demand for money may exhibit instability.” It followed that “The optimum strategy depends on circumstances. Changing circumstances, as the Federal Reserve’s recent action shows, can determine changes in strategy.” Greenspan articulated a flexible risk management approach to monetary policy. To critics who argue that such an approach is “too undisciplined – judgmental, seemingly discretionary, and difficult to explain” (p. 5), he responded that tying “policy to the prescriptions of a formal rule is unlikely to lead to an improvement in economic performance” (p. 5). The importance of the nature of uncertainty for the choice of a monetary policy strategy has long been recognized in the academic literature. The study of the nature of this relationship within formal stochastic macroeconomic models has been...