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 7: Introduction, Part II

Richard T. Froyen and Alfred V. Guender

Extract

7. Introduction, Part 2 Current discussions of issues in monetary policy share a number of characteristics. First, there has been a move towards a new framework where the rate of inflation – and not the price level – features prominently. Second, the interest rate has replaced the money supply as the instrument of monetary policy. And finally, the new approach acknowledges the potency of monetary policy in the short run. More generally, the new framework emphasizes simplicity over complexity. It comprises a simple two-equation IS–Phillips Curve model where the output gap and the rate of inflation enter as the two endogenous variables in the closed economy framework. The Phillips Curve figures prominently in the new framework. Indeed the Phillips Curve replaces the static aggregate supply relation, the hallmark of the rational expectations model of the 1970s and 1980s. The resurgence of the Phillips Curve at the expense of the static aggregate supply relation is attributable to a variety of factors, with the renewed emphasis on the dynamic behavior of the price level being arguably the most important. The dynamic behavior of the price level is the subject of Chapter 8 where we take a closer look at various incarnations of the Phillips Curve. The shift towards a new theoretical framework where the rate of inflation takes center stage has coincided with the adoption of implicit or explicit inflation targeting strategies by a number of central banks. It is therefore conceivable that concern with meeting inflation targets...

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