Monetary Theory and Policy

This chapter introduces several monetary theory and policy issues. The first section: (i) covers the determination of the price of money as a financial asset, with its two components: fundamentals and bubbles; (ii) shows the possibility of multiple equilibria in a monetary economy, where money has no value at one equilibrium; and (iii) addresses the indeterminacy of the price of money when the central bank pegs the nominal interest rate. The second section presents the optimum quantity of money in a flexible price economy. The third section analyzes the liquidity trap in its modern version, with zero-lower bound nominal interest rate. The fourth section deals with the problem of dynamic inconsistency in the presence of incentives for decisions made in the present for the future not to be carried out. The fifth section introduces optimal monetary rules for the Keynesian and the new Keynesian models. The sixth section covers the smoothing of the interest rate by central bankers who prefer not to change the interest rate abruptly, but gradually, producing some inertia in the behavior of the interbank interest rate. The seventh section covers inflation targeting, a system adopted by several central banks around the world since the 1990s. The eighth section analyzes the operational procedures of monetary policy in the bank reserves market, where the central bank plays a dominant role. The ninth section shows how the term structure of interest rates can be introduced in short-term macroeconomic models. This framework allows analyzing the effect of central bank announcements of the interest rate on the output gap and the inflation rate.