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 generalized method of moments estimator is used to test a small structural model of the U.S. macroeconomy. As with vector autoregression studies, we view the observable variables as endogenous functions of a set of unobservable shocks. We assume expectations are formed rationally and model monetary policy as a regime rather than a series of discretionary interventions. We find money growth rate shocks to be the most important source of output fluctuations. Real shocks to the demand for capital, and portfolio shocks, are found to be important in explaining covariation between output growth and changes in inflation and interest rates. This paper tests a small structural model of the U.S. macroeconomy similar to the model discussed in Hartley and Walsh (1991). While the econometric theory is not new, our application of it is novel. The results of our investigation of U.S. business cycles will be of interest to business cycle theorists. Our econometric analysis takes seriously the notion (emphasized in Lucas 1977 for example) that the key feature of business cycles is a stable pattern of covariation between many economic aggregates, both contemporaneously and over a small number of periods into the past. It has become customary to summarize these patterns of covariation using vector autoregressions involving a small number of variables and lags.

A Generalized Method of Moments Approach to Estimating a "Structural

New Zealand was successful in switching from a moderate inflation regime to a low-inflation regime between 1986-92. This success is attributable both to a restrictive monetary policy, political support for the policy, and wide-ranging institutional reforms in the economy--including important changes in the institutional structure of the central bank. The Reserve Bank of New Zealand (RBNZ) Act of 1989 established a more independent central bank and a regime of inflation targeting in the form of Policy Target Agreements (PTA). It also held the Governor of the Bank accountable for deviations from the target. Following implementation of the Act, New Zealand underwent a rapid disinflation and has since maintained "underlying" inflation within a 0-3 percent band--policy success that many have attributed to the consistency and "credibility" of policy made possible by the new institutional arrangements. This paper reviews the disinflation process in New Zealand, measures its output cost, and evaluates the contribution to maintaining low inflation through enhanced "credibility" associated with the RBNZ Act.

Carl E. Walsh

Papers

A Generalized Method of Moments Approach to Estimating a "Structural

Disinflation in New Zealand