The science of monetary policy: an imperfect knowledge perspective

New Keynesian theory identifies a set of principles central to the design and implementation of monetary policy. These principles rely on the ability of a central bank to manage expectations precisely, with policy prescriptions typically derived under the assumption of perfect information and full rationality. In consequence the prevailing policy regime is credible and correctly understood by market participants. Despite considerable advances in understanding, recent events have engendered a reevaluation of the theory and practice of monetary policy. The challenging macroeconomic environment bequeathed by the financial crisis has led many to question the efficacy of monetary policy, and, particularly, question whether central banks can influence expectations with as much control as previously thought. The objective of this survey is to review what is understood about the challenges to the New Keynesian paradigm posed by imperfect knowledge and to assess the degree of confidence with which one should hold the basic prescriptions of modern monetary economics.