Up to this point in our analysis, we have mostly treated monetary and fiscal variables as exogenous parameters or as determined on the basis of exogenously given policy rules.
We have investigated how the parameters of policy rules affect the steady state, the convergence of economies toward the steady state, or fluctuations around the steady state.1
We now turn to a deeper discussion of the role of macroeconomic policy, starting with monetary policy.
Monetary policy is crucial for the determination of the price level and inflation in both new classical and new Keynesian models. However, for new Keynesian models, monetary policy is also one of the important determinants of aggregate fluctuations in output and employment. And because of its flexibility relative to fiscal policy, it is probably the most important type of stabilization policy.The analysis of monetary policy in the context of dynamic stochastic general equilibrium (DSGE) models allows us to focus both on the short- and long-run effects of policy, discuss the optimality or suboptimality of alternative policy rules, and consider how alternative institutional arrangements can result in the emergence of policy rules with different macroeconomic implications.
The design of policies that the monetary authorities should follow to control inflation and stabilize the real economy has always been one of the most important concerns of monetary economics and policymaking. There is wide agreement about the key macroeconomic objectives of monetary policy, which are none other than price stability and high and stable output and employment, but disagreements remain regarding the nature of appropriate policies.
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