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

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.

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

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Library of Congress

Imperfect Knowledge and Monetary Policy

Series: The Stone Lectures in Economics

Vítor Gaspar

European Central Bank, Frankfurt

Otmar Issing

European Central Bank, Frankfurt

Oreste Tristani

European Central Bank, Frankfurt

David Vestin

European Central Bank, Frankfurt

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