Dynamic Macroeconomics

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20
The Role of Monetary Policy
Up to this point in our analysis, we have mostly treated monetary and fiscal
variables as exogenous parameters or as determined on the basis of
exogenously given policy rules. We have investigated how the parameters of
policy rules affect the steady state, the convergence of economies toward the
steady state, or fluctuations around the steady state.
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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, monetary policy is
also one of the important determinants of aggregate fluctuations in output and
employment. And because of its flexibility relative to fiscal policy, it is
probably the most important type of stabilization policy.
The analysis of monetary policy in the context of dynamic stochastic
general equilibrium (DSGE) models allows us to focus both on the short- and
long-run effects of policy, discuss the optimality or suboptimality of
alternative policy rules, and consider 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 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

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employment, but disagreements remain regarding the nature of appropriate
policies.