“the real evils of changing price levels do not lie in these changes per se, but in the fact that they usually take us unawares” Fisher (1911).
In our analysis up to now, we have mostly treated monetary and fiscal variables as exogenous parameters or as determined on the basis of given policy rules. We have investigated how the parameters of policy rules affect either the steady state, or the convergence of economies towards the steady state, or fluctuations around the steady state.
We now turn to a deeper discussion of the role of macroeconomic policy, starting with monetary policy. Monetary policy is crucial for the determination of the price level and inflation in both “new classical” and “new keynesian” models. However, for “new keynesian” models it is also one of the important determinants of aggregate fluctuations, and, because of its flexibility, probably the most important type of stabilization policy.
The analysis of monetary policy in the context of dynamic stochastic general equilibrium models allows us to focus both on the short run and long run effects of policy, discuss the optimality or sub-optimality of alternative policy rules, and finally discuss how alternative institutional arrangements can result in the emergence of policy rules with different macroeconomic implications.
The design of policies that the monetary authorities should follow in order to control inflation and stabilize the real economy has always been one of the most important concerns of monetary economics and policymaking. There is wide agreement about the key macroeconomic objectives of monetary policy, which are none other than price stability and high and stable output and employment, but a number of other disagreements remain regarding the nature of appropriate policies.