Alternative Views of the Monetary Transmission Mechanism: What Difference Do They Make for Monetary Policy?

This paper examines how alternative views of the monetary transmission mechanism affect the choice of a monetary policy rule. The main finding is that many different structural models indicate that the same simple monetary policy rule—one in which the central bank’s target short-term interest rate reacts to inflation and to real output—would perform well. Such rules work well even in models where the monetary transmission mechanism has a relatively strong exchange rate channel. The models differ, however, in their implications for more complex monetary rules. Prepared for the Oxford Review of Economic Policy. This paper is an updated, revised, and shortened version of an earlier paper entitled, “The Monetary Transmission Mechanism and The Evaluation of Monetary Policy Rules,” presented at the Central Bank of Chile in September 20-21, 1999. I am grateful to David Vines for very helpful comments.