philosophy, politics & economics

economics & management

Macroeconomics
Week 5, Hilary 2014
Monetary Policy
Outline
In this tutorial we shall work with the 3 equation ISPCMR model that we developed last
week. We shall use the framework to analyse both the structure of monetary policy and spe-
cic policy recommendations. We shall represent the central bank by a reaction function that
provides both a nominal anchor and a path for interest rate adjustments. From this we can
consider a set of optimal monetary policy rules and examine the conditions under which this
can be achieved.
It will be useful to review your prelims material on the quantity theory of money; Key-
nesian and Monetarist money demand theories; narrow and broad measures of the money
supply; the creation of the money supply and credit multiplier; the monetary transmission
mechanism; the links between money and ination; and the costs and benets of ination.
We shall then focus more explicitly on the conduct of monetary policy, questioning why is
monetary policy the responsibility of appointed central bank committees rather than elected
governments? In doing so we shall consider the debate on rules versus discretion. We shall
focus on the time inconsistency problem in relation to the ination bias and the stabilisation.
Readings
Review chapter 3 of Carlin and Soskice (2006) and ensure that you are comfortable manipu-
lating the 3-equation ISPCMR model. Chapter 5 and 11.7 of Carlin and Soskice is the
essential reading.
Romer (2001), chapter 10 is also essential reading (skip the mathematics if you nd it tough
and focus on the implications).
Chapter 8 of Walsh (2003) provides an excellent discussion of the ination bias problem. The
level is quite high but focus on the summary discussing the evidence on ination bias.
Mankiw (2003) chapters 14 and 15 provide an introduction and policy debate, and Chapters
9 and 10 of Burda and Wyplosz (2009) provide background material.
Allsopp, C. and Vines, D. (2000), The assessment: Macroeconomic policy, Oxford Review of
Economic Policy, 16(4), pp. 132: Online link
Bernanke, B. S. and Mishkin, F. S. (1997) Ination targeting: A new framework for monetary
policy?, Journal of Economic Perspectives, 11(2), pp. 97116, discuss ination targeting.
The working paper is available for download here.
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Also see the speech by John Vickers on the UKs ination targeting performance, Vickers,
J. (1998), Ination targeting in practice: The UK experience. Bank of England Quarterly
Bulletin, 5(4), pp. 368375, availabe towards the end of this le.
Chapters 1 and 2 of Pierce, D. and Tysome, P. (1985), Monetary Economics, 2nd edition,
Butterworths, London, provide a good summary of monetary policy, which is slightly
dated now.
A classic reference on monetary policy is Barro, R. J. and Gordon, D. B. (1983) Rules, discre-
tion and reputation in a model of monetary policy, Journal of Monetary Economics, 12(1),
pp. 101121: Online link.
For the UK historical perspective see Cobham, D. (2002), The making of monetary policy in the
UK, 19752000, Financial Economics and Quantitative Analysis Series, Wiley & Sons,
or the more dated but focused Laidler, D. (1985) Monetary policy in Britain: Successes
and shortcomings, Oxford Review of Economic Policy, 1(1), pp. 3543: Online link
The seminal paper in time inconsistency is Kydland, F. E. and Prescott, E. C. (1977), Rules
rather than discretion: The inconsistency of optimal plans, Journal of Political Economy,
85(3), pp. 47391, Online link
Clarida, R., Gali, J. and Gertler, M. (1999), The Science of Monetary Policy: A New Keyne-
sian Perspective, Journal of Economic Literature, 37, pp. 16611707, discuss the stabiliza-
tion bias. Online link
Essay Questions
There are two essay questions this week. Coordinate with your tutorial partner to ensure that
you each answer a different question. Submit your essay to me by the given deadline and
bring a brief essay plan to the tutorial (condensing the essay that you submit) to give to your
tutorial partner.
1. Suppose the European Central Bank and the Federal Reserve in the US appear to follow
a similar Taylor rule. Does this imply they have similar objectives?
2. Policymakers would better attain their macroeconomic objectives if they had their dis-
cretion taken away from them. Discuss.
Short Questions
I do not require you to hand in solutions to these short questions. They should help to focus
your reading and give you an idea of what to expect in part A of the exam.
1. What is the relevance of private sector expectations and policy credibility in determining
successful monetary policy?
2. How does the policy-makers discount rate affect the speed of adjustment back to equi-
librium after a shock?
3. What happens to optimal monetary policy when other measures such as scal policy or
wage accords are available?
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4. How does uncertainty regarding the origins of shock or the structure of the economy
inuence the best policy response?
5. Explain what is meant by the statement that a government that is determined to reduce
ination may have a problem in achieving this outcome because of a lack of credibility.
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