Dynamic Macroeconomics

20.4 The Mechanics of Monetary Policy
Up to now we have been assuming that the central bank has been determining
inflation by appropriate use of its monetary policy instruments. However, we
have not specified the relation between inflation and the monetary policy
instruments.
As discussed in chapter 12, the two main instruments of monetary policy
are the money supply and the nominal interest rate. These two instruments are
not independent, but are related through the money demand function. Thus, if
the central bank wishes to achieve a given nominal interest rate target, it must
be prepared to supply the stock of money (liquidity) demanded at this
nominal interest rate. If the central bank wishes to achieve a given target for
the stock of money, then it must be prepared to accept the nominal interest
rate that equates the demand with the supply of money.

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We have already referred to the classic analysis of the appropriate choice
of monetary instrument by Poole [1970] and the demonstration by Sargent
and Wallace [1975] that, under rational expectations, a noncontingent interest
rate target leads to price level indeterminacy and instability. We have also
discussed why this problem does not arise in the case of contingent interest
rate rules that make the nominal interest rate depend on the price level
(McCallum [1981]), or a sufficiently sensitive positive function of inflation
in the context of a Wicksell [1898] or Taylor [1993] rule.
In any case, central banks have been consistently using interest rates as
their main monetary policy instrument.
confine our analysis of monetary policy to contingent rules for the nominal
interest rate, such as the Taylor [1993] rule.
Before we analyze such rules, it is worth delving a little deeper into the
mechanics of monetary policy.