Monetary Theory and Policy

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1 Monetary Theory and Policy Third Edition Carl E. Walsh The MIT Press Cambridge Massachusetts

2 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. For information about special quantity discounts, please This book was set in Times New Roman on 3B2 by Asco Typesetters, Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Walsh, Carl E. Monetary theory and policy / Carl E. Walsh. 3rd ed. p. cm. Includes bibliographical references and index. ISBN (hardcover : alk. paper) 1. Monetary policy. 2. Money. I. Title. HG230.3.W dc

3 Contents Preface Introduction xi xvii 1 Empirical Evidence on Money, Prices, and Output Introduction Some Basic Correlations Long-Run Relationships Short-Run Relationships Estimating the E ect of Money on Output The Evidence of Friedman and Schwartz Granger Causality Policy Uses The VAR Approach Structural Econometric Models Alternative Approaches Summary 31 2 Money-in-the-Utility Function Introduction The Basic MIU Model Steady-State Equilibrium Steady States with a Time-Varying Money Stock The Interest Elasticity of Money Demand Limitations The Welfare Cost of Inflation Extensions Interest on Money Nonsuperneutrality Dynamics in an MIU Model 61

4 vi Contents The Decision Problem The Steady State The Linear Approximation Calibration Simulation Results Summary Appendix: Solving the MIU Model The Linear Approximation Collecting All Equations Solving Linear Rational-Expectations Models with Forward-Looking Variables Problems 87 3 Money and Transactions Introduction Resource Costs of Transacting Shopping-Time Models Real Resource Costs CIA Models The Certainty Case A Stochastic CIA Model Search Summary Appendix: The CIA Approximation The Steady State The Linear Approximation Problems Money and Public Finance Introduction Budget Accounting Intertemporal Budget Balance Money and Fiscal Policy Frameworks Deficits and Inflation Ricardian and (Traditional) Non-Ricardian Fiscal Policies The Government Budget Constraint and the Nominal Rate of Interest Equilibrium Seigniorage Cagan s Model Rational Hyperinflation 159

5 Contents vii 4.5 The Fiscal Theory of the Price Level Multiple Equilibria The Fiscal Theory Optimal Taxation and Seigniorage A Partial Equilibrium Model Optimal Seigniorage and Temporary Shocks Friedman s Rule Revisited Nonindexed Tax Systems Summary Problems Money in the Short Run: Informational and Portfolio Rigidities Introduction Informational Frictions Imperfect Information The Lucas Model Sticky Information Learning Limited Participation and Liquidity E ects A Basic Limited-Participation Model Endogenous Market Segmentation Assessment Summary Appendix: An Imperfect-Information Model Problems Money in the Short Run: Nominal Price and Wage Rigidities Introduction Sticky Prices and Wages An Example of Nominal Rigidities in General Equilibrium Early Models of Intertemporal Nominal Adjustment Imperfect Competition Time-Dependent Pricing (TDP) Models State-Dependent Pricing (SDP) Models Summary on Models of Price Adjustment Assessing Alternatives Microeconomic Evidence Evidence on the New Keynesian Phillips Curve Sticky Prices versus Sticky Information Summary 262

6 viii Contents 6.5 Appendix: A Sticky Wage MIU Model Problems Discretionary Policy and Time Inconsistency Introduction Inflation under Discretionary Policy Policy Objectives The Economy Equilibrium Inflation Solutions to the Inflation Bias Reputation Preferences Contracts Institutions Targeting Rules Is the Inflation Bias Important? Summary Problems New Keynesian Monetary Economics Introduction The Basic Model Households Firms A Linearized New Keynesian Model The Linearized Phillips Curve The Linearized IS Curve Uniqueness of the Equilibrium The Monetary Transmission Mechanism Adding Economic Disturbances Sticky Wages and Prices Monetary Policy Analysis in New Keynesian Models Policy Objectives Policy Trade-o s Optimal Commitment and Discretion Commitment to a Rule Endogenous Persistence Targeting Regimes and Instrument Rules Model Uncertainty Summary Appendix 379

7 Contents ix The New Keynesian Phillips Curve Approximating Utility Problems Money and the Open Economy Introduction The Obstfeld-Rogo Two-Country Model The Linear Approximation Equilibrium with Flexible Prices Sticky Prices Policy Coordination The Basic Model Equilibrium with Coordination Equilibrium without Coordination The Small Open Economy Flexible Exchange Rates Fixed Exchange Rates Open-Economy Models with Optimizing Agents and Nominal Rigidities A Model of the Small Open Economy The Relationship to the Closed-Economy NK Model Imperfect Pass-Through Summary Appendix The Obstfeld-Rogo Model The Small-Open-Economy Model Problems Financial Markets and Monetary Policy Introduction Interest Rates and Monetary Policy Interest Rate Rules and the Price Level Interest Rate Policies in General Equilibrium Liquidity Traps The Term Structure of Interest Rates The Expectations Theory of the Term Structure Policy and the Term Structure Expected Inflation and the Term Structure Macrofinance Financial Frictions in Credit Markets 477

8 x Contents Adverse Selection Moral Hazard Monitoring Costs Agency Costs Macroeconomic Implications Does Credit Matter? The Bank Lending Channel The Broad Credit Channel Summary Problems Monetary Policy Operating Procedures Introduction From Instruments to Goals The Instrument Choice Problem Poole s Analysis Policy Rules and Information Intermediate Targets Real E ects of Operating Procedures Operating Procedures and Policy Measures Money Multipliers The Reserve Market A Simple Model of a Channel System A Brief History of Fed Operating Procedures After Other Countries Problems 555 References 559 Name Index 597 Subject Index 605

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