Monetary Policy Regimes

As discussed in Chapter 5, the concept of the time inconsistency problem suggests that without a monetary policy rule guiding how the central bank regulates money conditions in the economy, the conduct of monetary policy would not be credible nor effective. Without a monetary policy rule constraining the central bank on monetary-policy decisions, the public might not believe that the central bank would ultimately keep the promise of price stability, since there are always incentives for the central bank to backtrack on the policy and try to push unemployment down further, possibly at the cost of price stability. Without a monetary policy rule, the public's inflation expectations might thus not be properly anchored, and the central bank, for all its good intentions, might be unable to successfully control inflation and deliver price stability as promised. To effectively conduct monetary policy, the central bank thus needs to follow a monetary policy rule that will assure a rational public that a policy action will contribute positively to the overall welfare of the economy.