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Economics 361 Monetary Theory and Policy

Lahore University of Management Sciences

Summer 2005 Hamza Ali Malik


Office: 243
Phone: 2243
hamzaali@lums.edu.pk

Course Objectives
Academic thinking about monetary economics has changed drastically over the past decade and
so has the practice of monetary policy. Almost simultaneously, big advances were made in the
management of monetary policy on the one hand and in theoretical and empirical research on
monetary policy on the other hand. Our aim in this course will be to analyze in detail the aims,
conduct, influence and limitations of monetary policy. Keeping in view the recent developments,
this course focuses less on monetary theory and more on the theory of monetary policy. We will
examine most of the major topics within monetary economics so as to gain a sufficiently broad
understanding of the field, but the target will be a discussion of a small number of models that
are useful for gaining insight into policy-oriented issues such as alternative monetary policy
transmission mechanisms and appropriate targeting regimes. The successful adoption of a
monetary policy regime geared almost explicitly towards targeting inflation by central banks of
many developed countries is one such example. Another key objective is to provide a detailed
introduction to the state-of-the-art research in monetary economics that have been labeled The
New Neoclassical Synthesis. The new synthesis involves the systematic application of
intertemporal optimization and rational expectations to various decisions made by economic
agents in order to combine ideas of Keynesian and Classical economics. Moreover, it also
embodies the insights of Monetarists regarding the theory and practice of monetary policy. By
the end of the course, you should not only have a firm grasp of the fundamental issues in
monetary policy but also learn useful mathematical techniques --- method of undetermined
coefficients (used to solve dynamic rational expectation models) and dynamic optimization using
the Lagrangian method.

Lecture Times and Location


Monday - Thursday: 1145 --- 1325 in ( ). I strongly recommend that you attend all the lectures as
I will provide sufficiently detailed lecture notes and some additional material during the lectures.

Office Hours
Friday: 1430 --- 1630. If these times are inconvenient and/or if you need additional times please
do not hesitate to make appointments.

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Pre-requisites
Econ 211: Intermediate Microeconomics I
Econ 221: Intermediate Macroeconomics I
Econ 222: Intermediate Macroeconomics II

Text and Other Readings

A)- Required Text

Mishkin, F. S, and Serletis, A. (2005), The Economics of Money, Banking, and Financial
Markets, Second Canadian Edition, Addison Wesley Longman Publishers.

B)- Other Books

1)- McCallum, Bennett, (1989), Monetary Economics: Theory and Policy, Prentice Hall
Publishers.

2)- Laidler, David, (1993), The Demand for Money: Theories, Evidence and Problems, Fourth
Edition, Harper Collins Publishers.

3)- Bofinger, Peter, (2001), Monetary Policy: Goals, Institutions, Strategies, and Instruments,
Oxford University Press.

4)- Blinder, Alan, (1998), Central Banking in Theory and Practice, The MIT Press.

5)- Solow, Robert and John Taylor, (2001), Inflation, Unemployment, and Monetary Policy,
The MIT Press.

6)- Walsh, Carl, (2003), Monetary Theory and Policy, Second Edition, The MIT Press.

7)- Scarth, William, (1996), Macroeconomics: An Introduction to Advanced Methods, Second


Edition, Dryden Press.

8)- Mankiw, Gregory, (ed.), (1994), Monetary Policy, The University of Chicago Press.

C)- Survey Articles

1)- King, Robert, (2000), The New IS-LM Model: Language, Logic, and Limits, Federal
Reserve Bank of Richmond, Economic Quarterly, Vol. 86, No. 3, Summer, pp. 45-103.

2)- McCallum, Bennett, (2002), Recent Developments in Monetary Policy Analysis: The Roles
of Theory and Evidence, Federal Reserve Bank of Richmond, Economic Quarterly, Vol. 88,
No. 1, Winter, pp. 67-96.

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3)- Loayza, Norman, and Klaus Schmidt-Hebbel, (2002), Monetary Policy Functions and
Transmission Mechanism: An Overview, in Monetary Policy: Rules and Transmission
Mechanism, Series on Central Bank Analysis and Economic Policies, Volume IV, Bank of
Chile.

4)- King, Mervyn, (1999), Challenges for Monetary Policy: New and Old, in New Challenges
for Monetary Policy, A Symposium Sponsored by the Federal Reserve Bank of Kansas City.

5)- Gali, J., (2002), New Perspectives on Monetary Policy, Inflation, and the Business Cycle,
NBER Working Paper No. 8767.

6)- Sargent, T., (1999), A Primer on Monetary and Fiscal Policy, Journal of Banking and
Finance, vol. 23, pp. 1463 1482.

You may also want to browse articles published as Economic Letter by Federal Reserve
Bank of San Francisco. These articles are very brief (4/5 pages) and offer non-technical
accounts on various issues related to monetary policy and other topics.
(www.frbsf.org/publications/economics/letter/index.html)

D)- Useful Websites

Michael Woodfords homepage, http://www.princeton.edu/~woodford/

Lars Svenssons webpage, http://www.princeton.edu/~svensson

McCallums webpage, http://wpweb2k.gsia.cmu.edu/faculty/mccallum/mccallum.html

Fabio Ghironis syllabus, http://www2.bc.edu/~ghironi/moneysyll.html

Monetary Policy Rule homepage, http://www.standord.edu/~johntayl/PolRulLink.htm

Monetary Policy in Open Economies, http://www.geocities.com/monetaryrules/mpoe.htm

Monetary Economics, http://www.few.eur.nl/few/people/smant/m-economics/index.htm

State Bank of Pakistan , http://www.sbp.org.pk

Course Evaluation

Two Quizzes: I will announce the date during the lectures --- 20% of the grade.

Mid-term Exam: June 27th --- 30% of the grade.

Final Exam: The University will announce the date --- 50% of the grade.

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Lecture Topics

1)- Introduction

Understanding money.
Some stylized facts about money, prices and output.

- Walsh (2003), chapter 1

- Chritiano, L., M. Eichenbaum, and C. Evans, (1999), Monetary Policy Shocks: What
Have We Learned and to What End? in J. Taylor and M. Woodford (eds.),
Handbook of Macroeconomics, Vol. 1A, Chapter 2, Elsvier North-Holland, pp. 65
148.

- Leeper, E., C. Sims, and T. Zha, (1996), What Does Monetary Policy Do?
Brookings Papers on Economic Activity, 2, pp. 1 63.

2)- Demand for Money

Quantity theory of money.


Keynes liquidity preference framework.
Transaction demand theory of money.
Friedmans modern quantity theory of money.

- Laidler (1993), various chapters.

3)- Monetary Policy: General Issues

Money supply process.


Monetary policy strategy and operating procedures.
Conduct of monetary policy: tools, goals and targets.

- McCallum, B. (1999), Issues in the Design of Monetary Policy Rules, in J.


Taylor and M. Woodford (eds.), Handbook of Macroeconomics, Vol. 1C, Chapter
23, Elsvier North-Holland, pp. 1483 1530.

- Schaechter, A. (2001), Implementation of Monetary Policy and the Central Banks


Balance Sheet, IMF Working Paper No. 01/149, October.

- Carare, A., A. Schaechter, M. Stone and M. Zelner (2002), Establishing Initial


Conditions in Support of Inflation Targeting, IMF Working Paper No. 02/102, June.

- Masson, P., Savastano, M., and S. Sharma, (1998), Can Inflation Targeting Be a
Framework for Monetary Policy in Developing Countries? Finance and
Development, March, IMF.

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- Kahn, M., (2003), Current Issues in the Design and Conduct of Monetary Policy,
IMF Working paper No. 03/56, March.

4)- Money in Macro Models I: Simple Models with Rational Expectations

The basic IS-LM/ AD-AS model --- static versus adaptive expectations.
Alternative monetary policy transmission mechanisms.
Introducing rational expectations: The Sargent-Wallace model.
Understanding the Lucas critique.
Solving rational expectations models --- method of undetermined coefficients.

- Sacrth (1996), chapter 5.

- Taylor, J., (2000), How the Rational Revolution Has Changed Macroeconomic
Policy Research, unpublished manuscript.

- Taylor, M., (1999), Real Interest Rates and Macroeconomic Activity, Oxford
Review of Economic Policy, Vol. 15, No. 2.

- Some simple and interesting papers relevant to the monetary transmission can be
found in, Symposium on the Monetary Transmission Mechanism, Journal of
Economic Perspectives (1995), Vol. 9, No. 4.

5)- Money in Macro Models II: New Models An Introduction

Dynamic general equilibrium monetary model: basic framework.


Learning Dynamic Optimization.
Deriving the new IS relationship.
Deriving the new Phillips curve.

- Walsh (2003), chapter 5.

- McCallum B., E. Nelson, (1999), An Optimizing IS-LM Specification for Monetary


policy and Business Cycle Analysis, Journal of Money, Credit and Banking,
August, pp. 296 316.

- Romer, D, (2000), Keynesian Macroeconomics without the LM Curve, Journal of


Economic Perspectives, Vol. 14, No. 2, Pages 149 169.

- Walsh, C, (2002), Teaching Inflation Targeting: An Analysis for Intermediate


Macro, Journal of Economic Education, Vol. 33, No. 4, pages 333 347.

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6)- Monetary Policy Analysis in the New Model

Optimal monetary policy.


Targeting regimes --- inflation, price level, and nominal GDP targeting.
Interest-rate rules.

- Walsh (2003), chapter 11.

- Clarida, R., K. Gali and M. Gertler, (2001), The Science of Monetary Policy: A
New Keynesian Perspective, Journal of Economic Literature, December, pp. 1661
1707.

- Bernake, B., and F. Mishkin, (1997), Inflation Trageting: A New Framework for
Monetery Policy?, The Journal of Economic Perspectives, Vol. 11, Issue 2, pp. 97
116.

- Mishkin, F., (1999), International Experiences with Different Monetary Policy


Regimes, Journal of Monetary Economics 43, pp. 579 605.

- Woodford, M., (2000), Pitfalls of Forward-Looking Monetary Policy, American


Economic Review, May, pp. 100 -104.

- Woodford, M., (2001), The Taylor Rule and Optimal Monetary Policy, American
Economic Review, May, pp. 232 237.

- McCallum, B., (2001), Should Monetary Policy Respond Strongly to Output Gaps,
American Economic Review, May, pp. 258 262.

7)- Discretionary Policy and Time Inconsistency

Implications of discretionary policy: traditional vs. new model.


Advantages of pre-commitment.
Solutions to the inflation bias problem.

- Walsh (2003), chapter 8.

- Beddies, C, H. (2000), Selected Issues Concerning Monetary Policy and


Institutional Design for Central Banks: A Review of Theories, IMF Working Paper
No. 00/140, August.

- Dennis, R., (2003), Time-Inconsistent Monetary Policies: Recent Research, Federal


Reserve Board of San Francisco, Economic Letter, No. 2003-10.