A Positive Theory of Monetary Policy in a Natural Rate Model

TLDR

Discretionary policy can generate surprise inflation that harms employment and boosts revenue, but when agents understand the policy goals such surprises are avoided, and the resulting long‑term commitments between government and private sector support a preference for rule‑based policy. In equilibrium people form expectations rationally and the policymaker optimizes each period subject to how expectations are formed. The model shows that monetary growth and inflation are excessive and driven by the Phillips‑curve slope, natural unemployment, and other benefit‑cost factors; the authority acts countercyclically; unemployment is decoupled from money policy; and outcomes improve when future policy is committed by rules.

Abstract

A discretionary policymaker can create surprise inflation, which may reduce employment and raise government revenue. But when people understand the policymaker's objectives, these surprises cannot occur systematically. In equilibrium people form expectations rationally and the policymaker optimizes in each period, subject to the way that people form expectations. Then, we find that (1) the rates of monetary growth and inflation are excessive; (2) these rates depend on the slope of Phillips curve, the natural unemployment rate, and other variables that affect the benefits and costs from inflation; (3) the monetary authority behaves countercyclically; and (4) unemployment is independent of money policy. Outcomes improve if rules commit future policy choices in the appropriate manner. The value of these commitments--which amount to long-term contracts between the government and the private sector--underlies the argument for rules over discretion.