Monetary Rule
Why inflation is avoided:
● Erodes savings and inhibits growth
● Difficult to plan and discourages investment
● Causes capital flight
● Can cause social and political unrest
Current monetary policy framework
● 1980s - failure of Monetarism and monetary targeting
○ Failure of the govt / central bank to control money supply (the main tool
of monetary policy)
● Inflation targeting - 2%
○ Changing the interest rate
○ Responding to economic shocks in the short run
○ Price stability is a quantitative target for inflation
● Transparency and accountability
○ The central bank publishes the monetary policy record
○ Publicly available information about how monetary policyC members
voted and why
● Based on a wide range of info, e.g. forecasting
● The Taylor Rule sets how the central bank should set the interest rate in
response to deviations from output and inflation
● Bank of Japan Act (2012) - monetary policy should aim for price stability
● Federal Reserve - objectives are maximum employment, stable prices,
moderate LR interest
● BoE - low inflation and support growth and employment objectives
○ 2nd mandate of low unemployment to the relationship between
unemployment and inflation
● The central bank has a strong technical capacity to model the economy
○ Models are theoretically based and data-driven
○ New Keynesian models - forward-looking with rational expectations
○ Dynamic Stochastic General Equilibrium (DSGE) models use micro-
foundations and forward-looking behaviour
● A government with a preference for output > equilibrium will end up with
inflation bias built into the system but output > potential
Deriving the Monetary rule
● Active / Taylor rule-based monetary policy - the best response real interest
rate to achieve the inflation target
○ Lower interest today decreases demand tomorrow
● To derive the monetary rule:
Why inflation is avoided:
● Erodes savings and inhibits growth
● Difficult to plan and discourages investment
● Causes capital flight
● Can cause social and political unrest
Current monetary policy framework
● 1980s - failure of Monetarism and monetary targeting
○ Failure of the govt / central bank to control money supply (the main tool
of monetary policy)
● Inflation targeting - 2%
○ Changing the interest rate
○ Responding to economic shocks in the short run
○ Price stability is a quantitative target for inflation
● Transparency and accountability
○ The central bank publishes the monetary policy record
○ Publicly available information about how monetary policyC members
voted and why
● Based on a wide range of info, e.g. forecasting
● The Taylor Rule sets how the central bank should set the interest rate in
response to deviations from output and inflation
● Bank of Japan Act (2012) - monetary policy should aim for price stability
● Federal Reserve - objectives are maximum employment, stable prices,
moderate LR interest
● BoE - low inflation and support growth and employment objectives
○ 2nd mandate of low unemployment to the relationship between
unemployment and inflation
● The central bank has a strong technical capacity to model the economy
○ Models are theoretically based and data-driven
○ New Keynesian models - forward-looking with rational expectations
○ Dynamic Stochastic General Equilibrium (DSGE) models use micro-
foundations and forward-looking behaviour
● A government with a preference for output > equilibrium will end up with
inflation bias built into the system but output > potential
Deriving the Monetary rule
● Active / Taylor rule-based monetary policy - the best response real interest
rate to achieve the inflation target
○ Lower interest today decreases demand tomorrow
● To derive the monetary rule:
