What are the Right Models and Policies for a World of Low Inflation?

Abstract

Monetary policy should be guided by macroeconomic models with limited nominal rigidity; ‘New Classical’ or even for some issues just plain Classical (i.e. with no nominal rigidity at all) models are perfectly adequate for understanding various aspects of the economy that have previously led economists to believe in a high degree of nominal rigidity. On UK data these models account for the facts of inflation persistence and exchange rate ‘overshooting’; their impulse responses are in line with the data; and a typical example, the Liverpool Model, is marginally accepted in its entirety by the data since 1979. Such models suggest that no increased macro instability would result from taking the rigours of monetary policy one stage further from inflation targeting and ensuring that the price level itself is returned to its long-run preset target path — so that the value of money over long periods of time would be utterly predictable.