the difficulty has been that, deregulation, financial innovation, and other factors have led to recurrent
instability in the relationships between various monetary aggregates and other nominal variables.”
4
. See Clarida et al. [1999], Woodford [2003a, 2011] Gali [2008, 2011a,b], and Taylor and Williams
[2011] for surveys of the findings of this literature. Woodford [2003a] and Orphanides [2003c, 2008]
survey the analysis of interest rate rules from Wicksell [1898] to Taylor [1993].
5
. One could of course use the staggered pricing model of chapter 16 to analyze optimal monetary
policy. For analyses of monetary policy based on this type of new Keynesian model, see Woodford
[2003a] and Gali [2011b]. Central banks increasingly use empirically estimated generalized new
Keynesian models with both price and wage rigidities to evaluate policy. Such models have been
calibrated, estimated, and empirically implemented by Erceg et al. [2000], Smets and Wouters [2003,
2007], Christiano et al. [2005], and others. However, not all of these models are analytically tractable.
Simpler models, such as the ones we utilize, are better for highlighting the theoretical basis of the
mechanisms at work.
6
. Equation
(20.2)
is the expectations-augmented Phillips curve derived in chapter 17, with the additional
restriction of lack of persistence (i.e., by imposing
δ
= 0).
7
. As demonstrated in chapter 15, the same outcome would be a feature of an ad hoc model of an
expectations-augmented Phillips curve under adaptive expectations. The only difference is that the
process of convergence to the equilibrium with high inflation will take more time when expectations are
formed adaptively. For a collection of early papers on the issue of credibility of monetary and fiscal
policy, see Persson and Tabellini [1994a].
8
. As noted by Friedman [1968, p. 13]: “Our economic system will work best when producers and
consumers, employers and employees, can proceed with full confidence that the average level of prices
will behave in a known way in the future—preferably that it will be highly stable.”
9
. For example, the Mortensen-Pissarides model that we examined in chapter 18 can be used to suggest
some such policies. See Pissarides [2000].
10
. The analysis of the significance of reputational mechanisms in repeated games is due to Kreps and
Wilson [1982a, b].
11
. See chapter 12, or Woodford [2003a, chapter 1] for the relevant arguments.
12
. See Capie et al. [1994]. As noted by Bernanke [2006, p. 2], “In practice, the difficulty has been that,
deregulation, financial innovation, and other factors have led to recurrent instability in the relationships
between various monetary aggregates and other nominal variables.”
13
. Obviously, these rules can always be expressed as contingent rules for the money supply by
substituting for the nominal interest rate in a money demand function and solving for the money supply.
14
. Taylor [1993, 1999] proposed a rule in which the natural real rate of interest was constant at 2% and
the inflation target was equal to 2% as well. Let us term this rule the
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