Monetary Theory and Policy

Abstract

This chapter introduces several monetary theory and policy issues. Section 11.1 covers the determination of the price of money as a financial asset, with its two components of fundamentals and bubbles; shows the possibility of multiple equilibria in a monetary economy, where money has no value at one equilibrium; and addresses the indeterminacy of the price of money when the Central Bank pegs the nominal interest rate. Section 11.2 presents the optimum quantity of money in a flexible price economy. Section 11.3 analyzes the liquidity trap in its modern version, with a zero-lower bound nominal interest rate. Section 11.4 deals with the problem of dynamic inconsistency in the presence of incentives for decisions made in the present for the future not to be carried out. Section 11.5 covers the smoothing of the interest rate by central bankers who prefer not to change the interest rate abruptly, but gradually, producing some inertia in the behavior of the interbank interest rate. Section 11.6 covers inflation targeting, a system adopted by several Central Banks around the world since the 1990s. Section 11.7 analyzes the operational procedures of monetary policy in the bank reserves market, where the Central Bank plays a dominant role. Section 11.8 shows how the term structure of interest rates can be introduced in short-term macroeconomic models. This framework allows for the analysis of the effect of Central Bank announcements of the interest rate on the output gap and the inflation rate.