Monetary Theory and Policy

Third Edition
Carl E. Walsh

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 rst-year
graduate courses in macroeconomics because it provides a more in-depth treatment of ination
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 rst 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 reect the dominance of the new Keynesian approach.
In the introduction to the rst edition, I cited three innovations of the book: the use of calibration
and simulation techniques to evaluate the quantitative signicance of the channels through which
monetary policy and ination aect 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 eld, 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 suciently broad coverage of the eld, but
the focus within each topic is often on a small number of papers or models that I have found useful
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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 reects an assessment that to do these topics justice, while still providing
enough emphasis on the core insights oered 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 14 is similar to that of the second edition. Signicant 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 ination are more fully discussed.
The rst-order conditions for the households 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 Uhligs 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 rst, 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 511 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 Lucass 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 ination 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
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includes a new section on macronance 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 reect my own biases toward research motivated by policy questions or
inuential in aecting the conduct of monetary policy. The eld 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 oer 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 rst 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 rst 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 rst edition. Attempting to
address the issues they raised greatly improved the nal 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 rst 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 oered helpful comments and assistance in preparing the second edition. I
would like particularly to thank Henning Bohn, Betty Daniel, Jordi Gal , 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 Simoes, David Coble Ferna ndez, David Florian-Hoyle, Jonathan Benchimol, Carlo
Migliardo, Oliver Fries, Yuichiro Waki, Cesar Carrera, Federico Guerrero, Beka Lamazoshvili, Rasim
Mutlu, A lvaro 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 rst and second
editions, and Deborah Cantor-Adams, production editor, and Alice Cheyer, copy editor, for this
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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.