Working Paper: NBER ID: w1114
Authors: Michael Dotsey; Robert G. King
Abstract: This paper explores the implications of rational expectations and the aggregate supply theory advanced by Lucas (1973) for analysis of optimal monetary policy under uncertainty along the lines of Poole (1970), returning to a topic initially treated by Sargent and Wallace (1975). Not surprisingly, these two "classical"concepts alter both the menu of feasible policy choice and the desirability of certain policy actions. In our setup, unlike that of Sargent and Wallace (1975),the systematic component of monetary policy is a relevant determinant of the magnitudeof "business fluctuations" that arise from shocks to the system. Central bank behavior--both the selection of monetary instruments and the framing of overall policyrespJnse to economic conditions--can work to diminish or increase the magnitude of business fluctuations. However, the "activist" policies stressed by the present discussion bear little (if any) relationship to the policy options rationalized by the conventional analysis of monetary policy under uncertainty. In particular,in contrast to Poole's analysis, money supply responses to the nominal interestrate are not important determinants of real economic activity. Rather, the central bank should focus on policies that make movements in the general price level readily identifiable by economic agents.
Keywords: monetary policy; rational expectations; business fluctuations
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| systematic component of monetary policy (E52) | magnitude of business fluctuations (E32) |
| choice of monetary instruments (E42) | variability of output (E23) |
| pegging the interest rate (E43) | economic fluctuations (E32) |
| feedback policies (D78) | information content of prices (E30) |
| information content of prices (E30) | real activity (E23) |
| policy which introduced a negative correlation between money and output fluctuations (E39) | magnitude of fluctuations (E32) |