RDP 7903: Monetary Rules: A Preliminary Analysis 4. The Results so far

The results reported in this paper suggest a clear role for monetary policy. Controlling the growth of money in RBA79 substantially reduces the level and variability of inflation in the medium and long run. It does this by slightly reducing the variability of the cyclical response of output and employment for most shocks, and by slightly increasing their initial variability when the impulses consist of a change in real wages or in the demand for money.

If the aim of macroeconomic policy is to minimise the variability in the short-run of the response of inflation, the growth of output and employment to shocks, then the conclusions of Poole's (1970) analysis hold for RBA79. In the medium to long-run, however, the variability of inflation and activity may be less when money is controlled even for a change in the demand for money. As noted in the sensitivity analysis, the results are more Pooleian when the model is modified to make prices and wages exogenous.

As these results illustrate, accommodating a change in the demand for money may produce a better outcome in the short-run and this result may hold for some other financial impulses. It will however, be difficult to tell whether a change in the demand for money has occurred,^[16] which illustrates one aspect of the information problem. It is therefore comforting to note that in the model with variable prices attempting to maintain money at its target level (in this analysis the control solution value) produces results which are not very different to those with a fixed bond rate.

Any evaluation of policy rules should also take into accou the underwriting problem. Much of the current analysis examines the reaction to individual exogenous shocks. In determining rules for the conduct of monetary policy, or how to react to a particular disturbance, it is necessary to form judgments about the effect of t decision or decision rule on the probability of future shocks. In the illustrative case examined, an inflationary impulse was not contained by controlling the money supply, a rise in the household saving ratio was assumed to follow, and a further inflationary and unemployment raising impulse occurred. This suggests a way in which monetary policy may have an important medium term effect on employment as well as inflation.

The current paper represents only an early attempt to come to grips with the issue of monetary rules with a moderately complex econometric model. The shocks considered in this paper are relatively simple and small in the sense that the structure of the model is unchanged by the shocks. Large shocks might produce qualitatively different behaviour in the economy (although not in the linear version of RBA79), and other shocks might have different implications for policy rules. The relationships in RBA79 might be specified in a way which biases the results. Future work should examine further the sensitivity of the results to the assumptions, including the effects of using a linearised model, and consider the use of other instruments of monetary policy.

Footnote

If the approach to monetary dynamics in RBA79 is correct, a change in the demand function for money could be inferred only indirectly, by the occurrence of systematic errors in the simulation performance of the model. By contrast, unexpected changes in government spending, exports, household expenditure and in award wages may be recognised more easily. [16]