Deconstructing the Art of Central Banking

IMF Working Papers, October 1, 2004

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The paper proposes a markedly different transmission mechanism from monetary policy to the macroeconomy, focusing on how policy changes nominal inertia in the Phillips curve.
Using recent theoretical developments, the authors examine a small, estimated U.S. monetary model distinguishing four monetary regimes employed since the late 1950s.
Main finding: changes in monetary policy are linked to shifts in nominal inertia, and improvements in supply-side flexibility (via reduced nominal inertia) are the main channel through which monetary policy lowers the volatility of inflation and, even more importantly, output.

Approach: analysis based on recent theoretical developments and estimation of a small U.S. monetary model.
Model structure: distinguishes four monetary regimes employed since the late 1950s.
Emphasis on the Phillips curve and nominal inertia as the transmission mechanism linking policy to macroeconomic outcomes.

Changes in monetary policy correlate with shifts in nominal inertia.
Reductions in nominal inertia (improvements in supply-side flexibility) are the principal channel through which monetary policy:
- Lowers the volatility of inflation.
- Lowers the volatility of output (noted as even more important than inflation volatility reductions).

Subject: Econometric analysis, Estimation techniques, Financial services, Inflation, Inflation targeting, Output gap, Prices, Production, Real interest rates
Keywords: Estimation techniques, inflation, inflation dynamics, inflation inertia, inflation uncertainty, inflation volatility, monetary policy, monetary policy uncertainty, Output gap, rational expectation models, reaction function, Real interest rates, WP