A new model of central-bank intervention: some examples

Optimal monetary policy is studied, by way of numerical examples, in a model with (i) heterogeneity in the degree to which different people are monitored (have publicly known histories); (ii) idiosyncratic shocks that give rise to heterogeneity in earning and spending realizations; and (iii) central-bank intervention in a “market” in claims or credit in which the participants are those who are heavily monitored. The results serve as counterexamples to two widely held views: optimal policy is unrelated to what makes money important; and, there are simple and well-known principles to guide monetary policy. Epigraph [For the Bank of England in 1805] knowing the direction of the wind was [important] ... If ... from the east, ships would soon be sailing up the Thames to unload goods in London. The Bank would need to supply lots of money..... If a westerly was blowing, the Bank would mop up any excess money..., thereby avoiding inflation. The 19th century Bank knew the importance of money ..., Mervyn King, the current governor, told the FT in an interview .... But money matters were much simpler in 1805 than today (“Winds of change” by Chris Giles, Financial Times, (FT), May 14, 2007).