The Theory of Monetary Policy: A Review

This paper reviews the main developments in the theory of monetary policy that have taken place since the early decades of the 20th century. The starting point of the review is the quantity theory of money as a basis for monetary policy conduct under the Gold Standard. The collapse of the Gold Standard and empirical evidence, which cast doubts on the validity of the quantity theory of money, brought about a strand of literature on monetary conduct. The focal points were the analysis on time-inconsistency problems, i.e. rule against discretion, and alternative approaches to impose constraints on monetary policy conduct to achieve the optimal results. The paper accounts for series of theoretical developments under different frameworks- from the early type of model under static framework with flexible prices to the most recent dynamic framework with sticky prices in the New Keynesian fashion. A conclusion could be drawn in favour of a monetary policy conduct under rule.