Monetary instruments and policy rules in a rational expectations environment

This paper explores the implications of rational expectations and the aggregate supply theory advanced by Lucas (1973) and Barro (1976) for analysis of optimal monetary policy under uncertainty along the lines of Poole (1970), returning to a topic initially treated by Sargent and Wallace (1975). Not surprisingly, these two ‘classical’ concepts alter both the menu of feasible policy choice and the desirability of certain policy actions. In our setup, unlike that of Sargent and Wallace (1975), the systematic component of monetary policy is a relevant determinant of the magnitude of ‘business fluctuations’ that arise from shocks to the system. Central bank behavior — both the selection of monetary instruments and the framing of overall policy response to economic conditions — can work to diminish or increase the magnitude of business fluctuations. However, the ‘activist’ policies stressed by the present discussion bear little (if any) relationship to the policy options rationalized by the conventional analysis of monetary policy under uncertainty. In particular, in contrast to Poole's analysis, money supply responses to the nominal interest rate are not important determinants of real economic activity. Rather, the central bank should focus on policies that make movements in the general price level readily identifiable by economic agents.