
Imperfect Knowledge and Monetary Policy
Based on lectures given as part of The Stone Lectures in Economics, this book discusses the problem of formulating monetary policy in practice, under the uncertain circumstances which characterize the real world. The first lecture highlights the limitations of decision rules suggested by the academic literature and recommends an approach involving, first, a firm reliance on the few fundamental and robust results of monetary economics and, secondly, a pragmatic attitude to policy implementation, taking into consideration lessons from central banking experience. The second lecture revisits Milton Friedman’s questions about the effects of active stabilization policies on business cycle fluctuations. It explores the implications of a simple model where the policy maker has imperfect knowledge about potential output and the private sector forms expectations according to adaptive learning. This lecture shows that imperfect knowledge limits the scope for active stabilization policy and strengthens the case for conservatism.
OTMAR ISSING is a member of the Executive Board, European Central Bank.
VÍTOR GASPAR is Special Advisor, Banco de Portugal.
ORESTE TRISTANI is Principal Economist, DG Research, European Central Bank.
DAVID VESTIN is Economist, DG Research, European Central Bank.
THE STONE LECTURES IN ECONOMICS
Already published:
Statistics, Econometrics and Forecasting – Arnold Zellner
Sir Richard Stone, Nobel Laureate in Economics.
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THE STONE LECTURES IN ECONOMICS
Imperfect Knowledge and Monetary Policy
Otmar Issing and Vítor Gaspar
with
Oreste Tristani and David Vestin
CAMBRIDGE UNIVERSITY PRESS
Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo
Cambridge University Press
The Edinburgh Building, Cambridge CB2 2RU, UK
Published in the United States of America by Cambridge University Press, New York
www.cambridge.org
Information on this title: www.cambridge.org/9780521671071
© Otmar Issing, Vítor Gaspar, Oreste Tristani and David Vestin 2005
This book is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without
the written permission of Cambridge University Press.
First published 2005
Printed in the United Kingdom at the University Press, Cambridge
A catalogue record for this book is available from the British Library
ISBN-13 978-0-521-85486-3 hardback
ISBN-10 0-521-85486-5 hardback
ISBN-13 978-0-521-67107-1 paperback
ISBN-10 0-521-67107-8 paperback
Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this book, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.
Contents
List of figures and table | page ix | |
Acknowledgments | xi | |
Introduction | 1 | |
Outline of the two lectures | 7 | |
Lecture 1: Monetary policy in uncharted territory | 12 | |
1.1 | Introduction | 12 |
1.2 | Uncharted territory: unique historical events | 15 |
1.3 | Achieving price stability | 23 |
1.4 | Avoiding excess volatility in inflation, output, and the interest rate | 38 |
1.5 | Pragmatic monetarism: the Bundesbank | 47 |
1.6 | A stability-oriented strategy: the ECB | 61 |
1.7 | Conclusions | 74 |
Lecture 2: Imperfect knowledge, learning, and conservatism | 77 | |
2.1 | Introduction | 77 |
2.2 | Time inconsistency, cost-push shocks and Rogoff ’s conservatism | 83 |
Empirical output gap uncertainty | 96 | |
2.4 | Output gap uncertainty, learning, and conservatism | 100 |
2.5 | Different degrees of central bank knowledge and information | 108 |
2.6 | Conclusions | 114 |
Notes | 117 | |
References | 122 | |
Index | 136 |
Figures and table
Figures | ||
1.1 | CPI Inflation, 1961–2001 | page 48 |
1.2 | Longer-term averages for German M3 and CPI developments, 1971–98 | 53 |
1.3 | M3 in Germany, 1988–98 | 56 |
1.4 | Annual rate of growth of M3 in Germany, 1988–98 | 58 |
1.5 | M3 money growth and HICP inflation in the euro area, 1994–2004 | 72 |
1.6 | Longer-term inflation expectations, 1999–2004 | 73 |
2.1 | Informational assumptions | 87 |
2.2 | Rational expectations, observable shocks | 90 |
2.3 | Loss: rational expectations with observable shocks | 91 |
2.4 | Private sector learning; central bank has perfect information | 94 |
2.5 | Loss: private sector learning | 95 |
2.6 | Real-time and two-sided estimates for the HP filter, and different UC models, for the euro area, 1980–2000 | 97 |
2.7 | Empirical properties of different estimates, euro area data, 1980–2000 | 99 |
2.8 | Central bank: imperfect information, private sector with fixed RLS coefficients | 102 |
2.9 | Loss: imperfect information, no private sector learning | 103 |
2.10 | Constant gain: learning and imperfect information | 105 |
2.11 | Losses with output gap uncertainty and private sector learning | 106 |
2.12 | From perfect to imperfect information | 110 |
2.13 | Loss functions : from perfect to imperfect information | 111 |
Table | ||
1.1 | Monetary targets and their implementation | 51 |
Acknowledgments
We wish to thank Klaus Adam, Steve Cecchetti, Athanasios Orphanides, Gerhard Rünstler, Frank Smets, and Caroline Willeke for helpful comments and suggestions on a preliminary draft. Sandrine Corvoisier and Björn Fischer provided excellent research assistance. We also wish to thank Patricia Kearns-Endres and Luisa Rey for editorial assistance and the organizers of the Stone Lectures Series at the Bank of England and at the National Institute for Economic and Social Research for their help. A final thank you to Chris Harrison for ensuring a smooth and pleasant interaction between the authors and the publisher