Evaluating the effects of monetary policy with economic models

Because of limited knowledge about how the actual, complex economy operates, policymakers depend on models for understanding its workings. For models to be usable for evaluating monetary policy effects, modelers must recognize that fluctuations or shocks in the actual economy are often driven by developments beyond the central bank's control. There are no simple rules, and neither is there a single model that represents the exact interactions between monetary policy and the rest of the economy. How good a model is depends on particular criteria. ; This article assesses the usability of a specific economic model for policy evaluation on the basis of certain criteria the economic literature recognizes. The author uses the model as an example to address a set of recurring questions regularly asked by policymakers, questions concerning projecting multiple key macroeconomic variables under alternative policy scenarios at the time when the policy decision has to be made. ; The discussion focuses on the two conceptual issues that are central to answering these questions: the baseline forecast and policy shifts. The author concludes that use of a baseline forecast serves only as a convenient technical tool for computing a menu of policy projections under alternative scenarios. The important message is that a combination, not a separation, of baseline forecast and identified policy shifts provides economically coherent ways of evaluating the effects of monetary policy.