Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability

Chapter 5Theoretical Foundations of the Practice of Modern Monetary Policy

Learning Objectives

• Describe theories that are foundational to the modern practice of monetary policy.
• Define and graph the short-run Phillips curve.
• Describe the natural rate of unemployment.
• Describe output gap.
• Distinguish between adaptive and rational expectations.
• Explain why operational independence of a central bank is important.

This chapter briefly reviews five theoretical developments that guide the modern practice of central banks in their pursuit of the monetary stability mandate. Specifically, these five theoretical developments, when considered together, suggest that central banks should conduct monetary policy by following a credible rule that aims for a low and stable inflation environment. A credible rule for the central bank’s conduct of monetary policy helps manage public expectations that the central bank will use monetary policy to achieve only what it does best, that is, ensure long-term price stability, as opposed to trying to push unemployment below the natural rate.

5.1 AN OVERVIEW OF THEORETICAL FOUNDATIONS

Five of the most influential theoretical developments that are foundational to the practice of monetary policy as we know it today are (1) the quantity theory of money, (2) the Phillips curve, (3) the natural rate of unemployment, (4) the rational expectations hypothesis, and (5) the time inconsistency problem. These five developments led to five propositions on the design ...