Policy Implications of the New Keynesian Phillips Curve

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The theoretical framework within which optimal monetary policy was studied before the arrival of the NewKeynesian Phillips curve (NKPC), but after economists had become comfortable using dynamic, optimizing, general equilibrium models and a welfare-maximizing criterion for policy analysis, was one in which the central source of nominal nonneutrality was a demand for money. At center stage in this literature was the role of money as a medium of exchange (as in cash-in-advance models, money-inthe- utility-function models, or shopping-time models) or as a store of value (as in overlapping-generations models). In the context of this family of models a robust prescription for the optimal conduct of monetary policy is to set nominal interest rates to zero at all times and under all circumstances. This policy implication, however, found no fertile ground in the boardrooms of central banks around the world, where the optimality of zero nominal rates was dismissed as a theoretical oddity, with little relevance for actual central banking. Thus, theory and practice of monetary policy were largely disconnected.

The early 1990s witnessed a profound shift in monetary economics away from viewing the role of money primarily as a medium of exchange and toward viewing money-sometimes exclusively-as a unit of account. A key insight was that the mere assumption that product prices are quoted in units of fiat money can give rise to a theory of price level determination, even if money is physically nonexistent and even if fiscal policy is irrelevant for price level determination.1 This theoretical development was appealing to those who regard modern payment systems as operating increasingly cashlessly. At the same time, nominal rigidities in the form of sluggish adjustment of product and factor prices gained prominence among academic economists. The incorporation of sticky prices into dynamic stochastic general equilibrium models gave rise to a policy tradeoff between output and inflation stabilization that came to be known as the New Keynesian Phillips curve.

The inessential role that money balances play in the New Keynesian literature, along with the observed actual conduct of monetary policy in the United States and elsewhere over the past 30 years, naturally shifted theoretical interest away from money growth rate rules and toward interest rate rules: In the work of academic monetary economists, Milton Friedman's celebrated k-percent growth path for the money supply gave way to Taylor's equally influential interest rate feedback rule.

In this article, we survey recent advancements in the theory of optimal monetary policy in models with a New Keynesian Phillips curve. Our survey identifies a number of important lessons for the conduct of monetary policy. First, optimal monetary policy is characterized by near price stability. This policy implication is diametrically different from the one that obtains in models in which the only nominal friction is a transactions demand for money. Second, simple interest rate feedback rules that respond aggressively to price inflation deliver near-optimal equilibrium allocations. Third, interest rate rules that respond to deviations of output from trend may carry significant welfare costs. Taken together, lessons one through three call for the adherence to an inflation targeting objective. Fourth, the zero bound on nominal interest rates does not appear to be a significant obstacle for the actual implementation of low and stable inflation. Finally, product price stability emerges as the overriding goal of monetary policy even in environments where not only goods prices but also factor prices are sticky.

Before elaborating on the policy implications of the NKPC, we provide some perspective by presenting a brief account of the state of the literature on optimal monetary policy before the advent of the New Keynesian revolution.

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