This paper reviews the recent literature on monetary policy rules. To organize the discussion, we exposit the monetary policy design problem within a simple baseline theoretical framework. We then consider the implications of adding various real word complications. We concentrate on developing results that are robust across a reasonable variety of competing macroeconomic frameworks. Among other things, we show that the optimal policy implicitly incorporates inflation targeting. We also characterize the gains from making credible commitments to fight inflation and consider the implications of frictions such as imperfect information and model uncertainty. Finally, we assess how proposed simple rules, such as the Taylor rule, square with the principles for optimal policy that we describe. We use this same metric to evaluate the recent course of U.S. monetary policy.

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The Science of Monetary Policy: A New Keynesian Perspective

The paper reviews the recent literature on monetary policy rules. We exposit the monetary policy design problem within a simple baseline theoretical framework. We then consider the implications of adding various real world complications. Among other things, we show that the optimal policy implicitly incorporates inflation targeting. We also characterize the gains from making a credible commitment to fight inflation. In contrast to conventional wisdom, we show that gains from commitment may emerge even if the central bank is not trying to inadvisedly push output above its natural level. We also consider the implications of frictions such as imperfect information.

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Interest and Prices

Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

Monetary Theory and Policy

Recursive methods offer a powerful approach in dynamic macroeconomics. This book contains both an introduction to recursive tools, including standard applications such as asset pricing, and advanced material, including analyses of reputational mechanisms and contract design. The tools are presented with enough technical sophistication to get the reader started working on practical problems. When numerical simulations are called for, the book provides suggestions for how to proceed, as well as references for further reading. The applications cover many substantive issues in macroeconomics, such as equilibrium asset prices, market incompleteness, wealth distribution, fiscal-monetary theories of inflation, government debt, optimal labour and capital taxation, time consistency and credible government policies, optimal social insurance, economic growth and labour market dynamics.

Recursive Macroeconomic Theory

A number of recent papers have focused on the role of real factors in accounting for the persistent effects of monetary shocks. These factors include habit persistence in consumption, variable capital utilization, and produced inputs. In this chapter, I focus on labor market rigidities that prevent unemployed workers from Þnding new jobs immediately and Þrms with job vacancies from Þlling them immediately. I employ dynamic simulations to investigate the role the job matching process plays in affecting the economy’s adjustment to real and monetary shocks. By combining labor market rigidities with sticky prices, it is possible to study the relative roles of real and nominal rigidities in accounting for the impact of monetary shocks.

Labour market search and monetary shocks

“Indeed, one of the first lessons one learns from studying a variety of hypothetical models is that the problem of economic stabilization is, even in principle, an extremely intricate one, and that a much more thorough investigation of both theoretical principles and empirical relationships would be needed before detailed policy recommendations could be justified.” A. W. Phillips (1957, reprinted 1965, p. 677)

Using monetary policy to stabilize economic activity

This paper evaluates the Reserve Bank of New Zealand Act of 1989 from a principal-agent perspective, arguing that the act represents a dismissal rule. The optimal dismissal rule requires that the central banker be dismissed whenever inflation exceeds a critical level that depends on aggregate supply disturbances and measurement error in the inflation index. This is essentially the structure established by the act. The scope for renegotiating the target rate, however, creates an incentive for the government to set the critical rate too high. Consequently, the inflation bias of discretion is reduced but not completely eliminated. Copyright 1995 by Ohio State University Press.

Is New Zealand's Reserve Bank Act of 1989 an Optimal Central Bank Contract?

Optimal Economic Transparency ∗ Carl E Walsh Department of Economics, University of California, Santa Cruz In this paper, I explore the optimal extent to which the central bank should disseminate information among private agents Individual ﬁrms are assumed to have diverse private information, and the central bank provides public information either implicitly, by setting its policy instrument, or explic- itly, by making announcements about its short-run targets The optimal degree of economic transparency is aﬀected diﬀer- ently by cost and demand shocks More-accurate central bank forecasts of demand shocks reduce optimal transparency, while more-accurate forecasts of cost shocks increase optimal trans- parency Increased persistence in demand (cost) disturbances increases (reduces) optimal transparency JEL Codes: E52, E58, E31 Introduction A major development in central banking in recent years has been the increase in monetary policy transparency Inﬂation-targeting central banks in particular have gone the furthest in adopting mechanisms to ensure greater transparency 1 Earlier versions of this paper were presented at “New Developments in the Analysis of Monetary Policy and Institutions,” a conference in honor of Alex Cukierman’s lifelong contributions to macroeconomics, the Sapir Center, Tel Aviv University, December 15–16, 2005; and the Bank of England’s Chief Economists Workshop, May 8–10, 2006 I would like to thank participants at these events, David Archer, Kevin Cowan, Akiva Oﬀenbacher, and Larry Schembri for help- ful comments on this and related research All remaining errors are my own E-mail: walshc@ucscedu In recent years, even central banks that have not formally adopted inﬂation targeting have become more transparent Eijﬃnger and Geraats (2006) provide an index of transparency for a set of developed economies that includes some inﬂation targeters (Australia, Canada, New Zealand, Sweden, and the United Kingdom) as well as nontargeters (Japan, Switzerland, and the United States)

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Optimal Economic Transparency

Over the last decade, many central banks have adopted policies known as inflation targeting. If intermediate-level macroeconomics students are to be prepared to think about current policy issues, it is important to provide them with an introduction to the macroeconomic implications of inflation targeting. Unfor- tunately, the standard aggregate demand-aggregate supply frameworks com- monly used to teach intermediate macroeconomics are not well suited for this task because they are expressed in terms of output and the price level and because they fail to make explicit the policy objectives of the central bank. The author provides a simple graphical device involving the output gap and the inflation rate that overcomes these problems and that can be used to teach intermediate macro- economics students about inflation targeting.

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Carl E. Walsh

Papers

Labour market search and monetary shocks

Using monetary policy to stabilize economic activity

Is New Zealand's Reserve Bank Act of 1989 an Optimal Central Bank Contract?

Optimal Economic Transparency

Teaching Inflation Targeting: An Analysis for Intermediate Macro