RDP 8905: Monetary Policy Instruments: A Theoretical Analysis 7. Conclusion

In the introduction to the paper, five questions were raised concerning the potential role of the short-term interest rate as an instrument of monetary policy. The analysis would appear to support the following conclusions.

1. An interest rate rule can tie down the price level provided the rule is specified so as to target some nominal level (such as money, prices or nominal income). Under such a rule, the interest rate would respond positively to any deviation of the relevant nominal variable from target. The mechanism by which policy works can be thought of as being through the effect of the real interest rate on real demand.
2. The case for interest rate rules as against money rules rests fundamentally on the stability of the money demand function. When money demand is sufficiently unstable, the optimal policy uses the interest rate instrument to target prices or nominal income, and gives no weight to targeting money.
3. A fixed interest rate rule, whether defined in terms of a nominal or a real rate, is not viable. However, simple rules can be devised in which the interest rate responds mechanically in proportion to the deviation of some chosen nominal variable from target. The appropriate size of the response factor depends upon the interest sensitivity of real demand: the smaller the interest sensitivity of demand, the larger is the interest rate responsiveness needed for a given deviation from target.
4. Assuming the money demand function is too unstable to be of practical use, the choice of target variable comes down to a choice between prices and nominal income. Of the two, the nominal income target always results in the more stable path for real output. The comparative variability of inflation as between the two cases is ambiguous, depending upon the relative importance of supply side and demand side shocks to the real economy.
5. Under the assumption that only unanticipated policy affects real output, there is no case for allowing base drift in the implementation of targets. This is because the difference between policies with and without base drift, amounts to a difference in response to failures to hit past targets; since these responses to past errors can be anticipated, they have no effect on output. However, a case for allowing base drift can be made if it is assumed that changes in actual (rather than just unanticipated) inflation are associated with real output effects. In this case, policy action to influence prices always has a real output effect, and it may therefore be judged undesirable to use policy to correct for past deviations of the price level from target.