Optimal Monetary Policy under Uncertainty
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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.
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Chapter 3: The Strategy of Monetary Policy: Targets, Instruments and Information Variables

Richard T. Froyen and Alfred V. Guender


Central to acting in an uncertain environment is an evaluation of information that is available. For monetary policy this is the question of an optimal strategy. In an important paper, Guttentag (1966) criticized the then current strategy of the Federal Reserve. That strategy focused on conditions in the money market as a guide to the conduct of open market operations. The Federal Reserve carried out open market operations to attain the desired level of “ease” or “tightness” in the money market. In practice this meant that the Federal Reserve reacted to various short-term (money market) interest rates and free reserves (excess minus borrowed reserves). The level of free reserves was the main quantitative measure used to gauge ease or tightness in the market.1 Guttentag criticized the Federal Reserve’s money market strategy as incomplete, in that it did not set specific quantitative target values for which it would hold itself accountable, for the money supply, long-term interest rate, or any other, “strategic variable” that could serve as connecting link between open market operations and system objectives. He argued that a complete strategy would be one that had several control periods where for each period “the function of the target is to facilitate the control over the next target in the sequence”. Second, “targets . . . should be precise and quantifiable”. Finally, with a complete strategy, “it should be possible to relate the final target in the strategy – the one with the longest control period – empirically to the system’s objective(s) (say...

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