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Monetary Instruments and Policy Rules in a Rational Expectations Environment

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1114.

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Date of creation: May 1983
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Publication status: published as Dotsey, Michael and Robert G. King. "Monetary Instruments and Policy Rulesin a Rational Expectations Environment." Journal of Monetary Economics, Vol. 12, No. 3, (September 1983), pp. 357-382.
Handle: RePEc:nbr:nberwo:1114

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  1. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  2. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  3. Santomero, Anthony M & Siegel, Jeremy J, 1981. "Bank Regulation and Macro-Economic Stability," American Economic Review, American Economic Association, vol. 71(1), pages 39-53, March.
  4. Laurence Weiss, 1978. "The Role for Active Monetary Policy in a Rational Expectations Model," Cowles Foundation Discussion Papers 491, Cowles Foundation for Research in Economics, Yale University.
  5. Poole, William, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, MIT Press, vol. 84(2), pages 197-216, May.
  6. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
  7. McCallum, Bennett T, 1980. "Rational Expectations and Macroeconomic Stabilization Policy: An Overview," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 12(4), pages 716-46, November.
  8. Barro, Robert J., 1976. "Rational expectations and the role of monetary policy," Journal of Monetary Economics, Elsevier, vol. 2(1), pages 1-32, January.
  9. Howitt, Peter W, 1981. "Activist Monetary Policy under Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 89(2), pages 249-69, April.
  10. Phelps, Edmund S & Taylor, John B, 1977. "Stabilizing Powers of Monetary Policy under Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 163-90, February.
  11. McCallum, B. T. & Whitaker, J. K., 1979. "The effectiveness of fiscal feedback rules and automatic stabilizers under rational expectations," Journal of Monetary Economics, Elsevier, vol. 5(2), pages 171-186, April.
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Cited by:
  1. Robert L. Hetzel, 1988. "The monetary responsibilities of a central bank," Economic Review, Federal Reserve Bank of Richmond, issue Sep, pages 19-31.
  2. Peter Stemp, 1993. "Optimal money supply rules under asymmetric objective criteria," Journal of Economics, Springer, vol. 57(3), pages 215-232, October.
  3. Jürgen Hagen & Manfred Neumann, 1990. "Relative price risk in an open economy with fixed and flexible exchange rates," Open Economies Review, Springer, vol. 1(3), pages 269-289, October.
  4. Michael Dotsey, 1987. "Monetary control under alternative operating procedures," Working Paper 87-05, Federal Reserve Bank of Richmond.
  5. Dotsey, Michael & King, Robert G, 1986. "Informational Implications of Interest Rate Rules," American Economic Review, American Economic Association, vol. 76(1), pages 33-42, March.
  6. Warren E. Weber, 1984. "Output variability in an open-economy macro model with variance-dependent parameters," Staff Report 94, Federal Reserve Bank of Minneapolis.
  7. Boyd Iii, J.H. & Dotsey, M., 1990. "Interest Rate Rules And Nominal Determinacy," RCER Working Papers 222, University of Rochester - Center for Economic Research (RCER).
  8. Robert L. Hetzel, 1993. "A quantity theory framework for monetary policy," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 35-48.
  9. Robert L. Hetzel, 2004. "How do central banks control inflation?," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 46-63.
  10. Robert L. Hetzel, 1986. "A critique of theories of money stock determination," Working Paper 86-06, Federal Reserve Bank of Richmond.
  11. Bali, Turan G. & Thurston, Thom B., 2002. "On the efficiency of monetary policy rules with flexible prices and rational expectations," Journal of Economics and Business, Elsevier, vol. 54(6), pages 615-631.
  12. W. Michael Cox & Douglas McTaggart, 1988. "Exchange and interest rate management and the international transmission of disturbances," Research Paper 8802, Federal Reserve Bank of Dallas.

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