Monetary Policy Instruments: A Theoretical Analysis

This paper provides a theoretical analysis of monetary policy rules specified in terms of an interest rate instrument, in contrast to the usual assumption that the instrument is a monetary quantity. The analysis is presented using a neoclassical dynamic model. It begins by summarising some standard results on price level determinacy, and then considers two major issues in the appropriate design of an operating rule for policy. The first concerns the choice of target, and specifically the choice between inflation and nominal income targets. The second issue concerns the distinction between targets with and without “base drift”. It is concluded that nominal income targeting produces lower output variability than an inflation target, but has an ambiguous effect on inflation variability. The case for allowing base drift in targets depends on whether or not anticipated policy is neutral; since base drift is essentially a revision to targets based on past information, allowance of base drift can only have an effect on output stability when anticipated policy in non-neutral. In this case, the analysis suggests that targets with base drift may produce more stable output paths than those without.