Preface

This book covers the most important topics in monetary economics and some of the models that economists have employed as they attempt to understand the interactions between real and monetary factors. It deals with topics in both monetary theory and monetary policy and is designed for second-year graduate students specializing in monetary economics, for researchers in monetary economics wishing to have a systematic summary of recent developments, and for economists working in policy institutions such as central banks. It can also be used as a supplement for first-year graduate courses in macroeconomics because it provides a more in-depth treatment of inflation and monetary policy topics than is customary in graduate macroeconomic textbooks. The chapters on monetary policy may be useful for advanced undergraduate courses.

In preparing the third edition of Monetary Theory and Policy, my objective has been to incorporate some of the new models, approaches, insights, and lessons that monetary economists have developed in recent years. As with the second edition, I have revised every chapter, with the goal of improving the exposition and incorporating new research contributions. At the time of the first edition, the use of models based on dynamic optimization and nominal rigidities in consistent general equilibrium frameworks was still relatively new. By the time of the second edition, these models had become the common workhorse for monetary policy analysis. And since the second edition appeared, these models have continued to provide the theoretical framework for most monetary analysis. They now also provide the foundation for empirical models that have been estimated for a number of countries, with many central banks now employing or developing dynamic stochastic general equilibrium (DSGE) models that build on the new Keynesian models covered in earlier editions.

This third edition incorporates new or expanded material on money in search equilibria, sticky information, adaptive learning, state-contingent pricing models, and channel systems of implementing monetary policy, among other topics. In addition, much of the material on models for policy analysis has been reorganized to reflect the dominance of the new Keynesian approach.

In the introduction to the first edition, I cited three innovations of the book: the use of calibration and simulation techniques to evaluate the quantitative significance of the channels through which monetary policy and inflation a¤ect the economy; a stress on the need to understand the incentives facing central banks and to model the strategic interactions between the central bank and the private sector; and the focus on interest rates in the discussion of monetary policy. All three aspects remain in the current edition, but each is now commonplace in monetary research. For example, it is rare today to see research that treats monetary policy in terms of money supply control, yet this was common well into the 1990s.

When one is writing a book like this, several organizational approaches present themselves. Monetary economics is a large field, and one must decide whether to provide broad coverage, giving students a brief introduction to many topics, or to focus more narrowly and in more depth. I have chosen to focus on particular models, models that monetary economists have employed to address topics in theory and policy. I have tried to stress the major topics within monetary economics in order to provide su‰ciently broad coverage of the field, but the focus within each topic is often on a small number of papers or models that I have found useful for gaining insight into a particular issue. As an aid to students, derivations of basic results are often quite detailed, but deeper technical issues of existence, multiple equilibria, and stability receive somewhat less attention. This choice was not made because the latter are unimportant. Instead, the relative emphasis reflects an assessment that to do these topics justice, while still providing enough emphasis on the core insights o¤ered by monetary economics, would have required a much longer book. By reducing the dimensionality of problems and by not treating them in full generality, I hoped to achieve the right balance of insight, accessibility, and rigor. The many references will serve to guide students to the extensive treatments in the literature of all the topics touched upon in this book.

While new material has been added, and some material has been deleted, the organization of chapters 1–4 is similar to that of the second edition. Significant changes have been made to each of these chapters, however. Chapter 2 includes a discussion of steady states with a time-varying stock of money; and the empirical evidence on money demand and the connection between the interest elasticity of money demand and the costs of inflation are more fully discussed. The first-order conditions for the household’s decision problem in the stochastic MIU model have been moved from an appendix into the text; the calibration for the simulation exercises has changed; and programs are provided (at hhttp://people.ucsc.edu/~walshc/mtp3ei) for solving the stochastic MIU model using eigenvalue decomposition methods based on the programs of Harald Uhlig, Paul So¨derlind, and Dynare as well as for employing an approach based on a linear regulator problem. Because Uhlig’s tool kit is not the only approach used, the discussion of his methodology has been shortened.

Similar changes with regard to the simulation programs have been made for the CIA model of chapter 3. In addition, the timing of the asset and goods markets has been changed for the model used to study dynamics. Asset markets now open first, which ensures that the cash-in-advance constraint always holds as long as the nominal interest rate is positive. The major change to chapter 3 is the extended discussion of the literature on money in search equilibrium. Less detail is now provided on the Kiyotaki and Wright (1989) model; instead, the main focus is on the model of Lagos and Wright (2005).

Chapter 4 has been shortened by eliminating some of the discussion of time series methods for testing budget sustainability.

Chapters 5–11 have seen a major revision. Chapters 5 and 6 focus on the frictions that account for the short-run impact of monetary policy. In previous editions, this material was entirely contained in chapter 5. Given the enormous growth in the literature on topics like sticky information and state-dependent pricing models, the third edition devotes two chapters to the topic of frictions. Chapter 5 focuses on models with information rigidities, such as Lucas’s island model and models of sticky information. It also discusses models based on portfolio frictions, such as limitedparticipation and asset-market-segmentation models. More formal development of a limited-participation model is provided, and a model of endogenous asset market segmentation is discussed. Chapter 6 focuses on nominal wage and price stickiness, and incorporates recent work on microeconomic evidence for price adjustment and research on state-contingent pricing models. The third edition focuses less on the issue of persistence in evaluating the new Keynesian Phillips curve but provides expanded coverage of empirical assessments of models of sticky prices, particularly related to the micro evidence now available.

Models of the average inflation bias of discretionary policy are discussed in chapter 7. Chapter 8 provides stand-alone coverage of new Keynesian models and their policy implications in the context of the closed economy. It incorporates material formerly split between chapters 5 and 11 of the second edition. The open economy is now the focus of chapter 9. Chapter 10 on credit frictions now includes a new section on macrofinance models as well as material on the term structure from the second edition. Finally, chapter 11, on operating procedures, has taken on a new relevance and provides a discussion of channel systems for implementing monetary policy.

It is not possible to discuss here all the areas of monetary economics in which economists are pursuing active research, or to give adequate credit to all the interesting work that has been done. The topics covered and the space devoted to them reflect my own biases toward research motivated by policy questions or influential in a¤ecting the conduct of monetary policy. The field has simply exploded with new and interesting research, and at best this edition, like the earlier ones, can only

scratch the surface of many topics. To those whose research has been slighted, I o¤er my apologies.

Previous editions were immensely improved by the thoughtful comments of many individuals who took the time to read parts of earlier drafts, and I have received many comments from users of the first two editions, which have guided me in revising the material. Luigi Buttiglione, Marco Hoeberichts, Michael Hutchison, Francesco Lippi, Jaewoo Lee, Doug Pearce, Gustavo Piga, Glenn Rudebusch, Willem Verhagen, and Chris Waller provided many insightful and useful comments on the first edition. Students at Stanford and the University of California, Santa Cruz (UCSC) gave important feedback on draft material; Peter Kriz, Jerry McIntyre, Fabiano Schivardi, Alina Carare, and especially Jules Leichter deserve special mention. A very special note of thanks is due Lars Svensson and Berthold Herrendorf. Each made extensive comments on complete drafts of the first edition. Attempting to address the issues they raised greatly improved the final product; it would have been even better if I had had the time and energy to follow all their suggestions. The comments and suggestions of Julia Chiriaeva, Nancy Jianakoplos, Stephen Miller, Jim Nason, Claudio Shikida, and participants in courses I taught based on the first edition at the IMF Institute, the Bank of Spain, the Bank of Portugal, the Bank of England, the University of Oslo, and the Swiss National Bank Studienzentrum Gerzensee all contributed to improving the second edition. Wei Chen, Ethel Wang, and Jamus Lim, graduate students at UCSC, also o¤ered helpful comments and assistance in preparing the second edition.

I would like particularly to thank Henning Bohn, Betty Daniel, Jordi Galı´, Eric Leeper, Tim Fuerst, Ed Nelson, Federico Ravenna, and Kevin Salyer for very helpful comments on early drafts of some chapters of the second edition. Many of the changes appearing in the third edition are the result of comments and suggestions from students and participants at intensive courses in monetary economics that I taught at the IMF Institute, the Swiss National Bank Studienzentrum Gerzensee, the Central Bank of Brazil, the University of Rome ‘‘Tor Vergata,’’ the Norges Bank Training Program for Economists, the Finnish Post-Graduate Program in Economics, the ZEI Summer School, and the Hong Kong Institute for Monetary Research. Students at UCSC also contributed, and Conglin Xu provided excellent research assistance during the process of preparing this edition.

Henrik Jenson read penultimate versions of many of the current chapters and provided a host of useful suggestions that helped improve the book in terms of substance and clarity. Others I would like to thank, whose suggestions have improved this edition, include Ulf So¨derstro¨m, Mario Nigrinis, Stephen Sauer, Sendor Lczel, Jizhong Zhou (who translated the second edition into Chinese), Oreste Tristani, Robert Tchaidze, Teresa Simo˜es, David Coble Ferna´ndez, David Florian-Hoyle, Jonathan Benchimol, Carlo Migliardo, Oliver Fries, Yuichiro Waki, Cesar Carrera, Federico

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Guerrero, Beka Lamazoshvili, Rasim Mutlu, Alvaro Pina, and Paul So¨derlind (and my apologies to anyone I have failed to mention). As always, remaining errors are my own.

I would also like to thank Jane Macdonald, my editor at the MIT Press for the third edition, Nancy Lombardi, production editor for both the first and second editions, and Deborah Cantor-Adams, production editor, and Alice Cheyer, copy editor, for this edition, for their excellent assistance on the manuscript. Needless to say, all remaining weaknesses and errors are my own responsibility. Terry Vaughan, my original editor at the MIT Press, was instrumental in ensuring this project got o¤ the ground initially, and Elizabeth Murry served ably as editor for the second edition.