Policy Implications of the New Keynesian Phillips Curve

T he theoretical framework within which optimal monetary policy was studied before the arrival of the New Keynesian Phillips curve (NKPC), but after economists had become comfortable using dynamic, optimizing, general equilibrium models and a welfare-maximizing criterion for policy analysis, was one in which the central source of nominal nonneutrality was a demand for money. At center stage in this literature was the role of money as a medium of exchange (as in cash-in-advance models, money-inthe-utility-function models, or shopping-time models) or as a store of value (as in overlapping-generations models). In the context of this family of models a robust prescription for the optimal conduct of monetary policy is to set nominal interest rates to zero at all times and under all circumstances. This policy implication, however, found no fertile ground in the boardrooms of central banks around the world, where the optimality of zero nominal rates was dismissed as a theoretical oddity, with little relevance for actual central banking. Thus, theory and practice of monetary policy were largely disconnected. The early 1990s witnessed a profound shift in monetary economics away from viewing the role of money primarily as a medium of exchange and toward viewing money—sometimes exclusively—as a unit of account. A key insight was that the mere assumption that product prices are quoted in units of fiat money can give rise to a theory of price level determination, even if money is physically nonexistent and even if fiscal policy is irrelevant for price