1 - Money, output and prices: the scope of monetary policy

Summary

In this chapter, we draw some basic lessons from the economic literature on what monetary policy can and cannot do. This is not an attempt to find prior justifications for an over restrictive interpretation of the central banker's mandate. Understanding the limits to monetary management is essential for the central banker to avoid mistakes. To be effective and credible, monetary policy makers need to be modest, or, to put it better, realistic, in the way they see the potential scope for their action.

The literature offers a wealth of analyses, evidence and suggestions on ‘what monetary policy can and cannot do’, an issue which has constantly been at the core of monetary economics (see Friedman, 1968).

Unfortunately, however, the discipline is still characterised by a substantial lack of agreement on the ‘appropriate model’ suitable for a unified analysis of monetary policy issues. ‘Whatever the particular model component that is singled out for special criticism, it seems extremely hard to avoid the conclusion that agreement …is predominantly absent’ (McCallum, 1999). Specifically, the key issue of how exactly monetary policy impacts on real variables over time is still only imperfectly understood and ‘different models carry highly different alleged implications for monetary policy’ (again, McCallum, 1999).

Moreover, empirical studies often cannot discriminate across competing models. Each model appears capable of replicating some stylised facts of modern economies, but it fails to portray the complex and multifaceted characteristics of the real world.