Monetary Indicators and Policy Rules in the P-Star Model

Abstract

There is a broad consensus among economists that, in the long run, inflation is a monetary phenomenon. However, monetary policy is often analysed using models that have no causal role for monetary aggregates in the propagation of inflationary processes. Moreover, impulses from monetary policy actions are transmitted to inflation through the output gap alone. This paper analyses monetary indicators and monetary policy rules within the framework of a small monetary model, the P-star model. In this model monetary aggregates play an active role in the transmission mechanism of monetary policy actions. Interest rate impulses affect inflation through two channels, the output gap and the liquidity gap. Section 2 of the paper analyses monetary indicators of inflation. Using a long-run money demand function, three monetary indicators are discussed: the monetary overhang, the price gap, and the nominal money gap. The price gap is a comprehensive indicator of inflationary pressure, combining information from the aggregate goods market (output gap) and the money market (liquidity gap). Some implications of using the price gap in Phillipstype equations for the dynamics of inflation are discussed as well. Section 3 analyses the role of the price gap in the monetary transmission process more closely. The P-Star model and a New-Keynesian-Taylor-type model are compared with respect to their stability properties, implied sacrifice ratios and the efficiency of interest rate policy in stabilising inflation and output fluctuations. Section 4 explores a range of monetary policy rules within the P-star model. First, direct inflation targeting, inflation forecast targeting, and optimal inflation targeting are analysed and contrasted with a strategy of price-level targeting, often suggested as an alternative to inflation-based rules. Second, assuming a more general loss function for the central bank, a Taylor rule (focussing on inflation and output), monetary targeting and a two-pillar strategy (focussing on monetary growth and inflation) are analysed. The performance of these rules is investigated under perfect foresight and rational expectations of the central bank. Moreover, these strategies are compared to two benchmarks, a passive rule and a broadly based meta-strategy. Finally, monetary targeting as an intermediate targeting strategy is compared to a Taylor rule when the central bank has an information advantage with respect to monetary growth.