RDP 9604: Issues in Modelling Monetary Policy^[1] 1. Introduction

Macroeconomic models embody two important sets of hypotheses about the role of monetary policy. The first concerns the operation of policy, or how the policy instrument reacts to wider economic developments. This aspect of model design involves assumptions about the choice of instrument, the form of decision-rules relating instruments to objectives and the operational meaning of a ‘no policy change’ assumption with respect to monetary policy. Secondly, models embody a range of hypotheses about how changes in policy-related variables influence the economy as a whole. The purpose of this paper is to give an overview of issues related to these two aspects of policy modelling, drawing on recent macroeconomic developments and on research conducted mainly at the RBA.

In Section 2 we discuss the monetary policy framework in Australia, and how it might relate to the policy assumptions built into macroeconomic models. In particular we discuss the role of money supplies and interest rates as policy variables, and advocate model specifications that fully recognise the short-term interest rate as the monetary policy instrument. This leads to a suggested emphasis on studying policy rules that differ in important ways from standard money-growth rules. Section 3 then gives a review of evidence, mainly from RBA sources, on the monetary transmission process, in order to draw some general conclusions about how monetary policy affects the economy and how this might be reflected in modelling strategies. The themes are drawn together in Section 4 with some general observations concerning pitfalls and limitations of model-based policy analysis.

Footnote

This paper was originally prepared for a conference of the Economic Modelling Bureau of Australia, held on 23 May 1996. The aim was to provide an introduction and background for a discussion of econometric model results, drawing on available Reserve Bank research. [1]