Monetary Policy and Real Stabilization

During the past two decades, maintenance of low inflation, “price stability,” has become the principal focus of central banks around the world. At the same time, the view has emerged that monetary policy is better suited than fiscal policy for short-run stabilization purposes. This paper examines to what extent monetary policy can be directed at both “monetary stabilization,” stabilizing inflation at a low level and “real stabilization,” stabilizing output or, rather, the output gap and whether there are significant limitations on the use of monetary policy for real stabilization purposes. Section 2 discusses what a realistic view of monetary policy is, what monetary policy realistically can and cannot achieve, what the long-run and short-run tradeoffs are between inflation and output, what the appropriate objectives for monetary policy are, and what the role of credibility is for the tradeoff between inflation and output stabilization. Section 3 discusses how central banks can make the objectives of low and stable inflation and a stable output gap precise and the benefits thereof, how central banks can achieve the best outcome relative to these objectives by a procedure called “forecast targeting,” and how this procedure is best implemented. Section 4 discusses how the objectives of financial stability and a well-functioning payment system can be taken into account and reconciled with the objectives of low and stable inflation and stable output gap, and to what extent central banks should respond to asset prices and bubbles. Section 5 discusses how the risks of hitting the