A non-technical explanation of technical aspect of monetary policy

Mishkin in his recent speechhas explained the technicalities in monetary policy really well. The speech basically covers that financial disruptions put a strain on the entire economy. So we need better risk management systems to make better monetary policy.

In particular, the standard textbook approach to analyzing optimal monetary policy utilizes a linear-quadratic (LQ) framework, in which the equations describing the dynamic behavior of the economy are linear and the objective function specifying the goals of policy is quadratic. For example, in light of the dual mandate, monetary policy is often characterized as seeking to minimize a loss function comprising the squared value of the inflation gap (that is, actual inflation minus desired inflation) and the squared value of the output gap (that is, actual output minus potential output).

While an LQ framework may provide a reasonable approximation to how monetary policy should operate under fairly normal circumstances, this approach is less likely to be adequate for thinking about monetary policy when the risk of poor economic performance is unusually high.

Reason: black swans

Most of the quantitative studies of optimal monetary policy have also assumed that the shocks hitting the economy have a time-invariant Gaussian distribution, that is, a classical bell curve with symmetric and well-behaved tails. In reality, however, the distribution of shocks hitting the economy is more complex. In some instances, the uncertainty facing the economy is clearly skewed in one direction or another; again, this is likely when there are significant financial disruptions.

So, how should monetary policy respond to these black swan kind of events?

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible

Read the speech for further details.

Meanwhile, I was also reading this fiscal stimulus primer(the latest buzzword is to give stimulus to the economy using fiscal policy) by Douglas W. Elmendorf and Jason Furman of Brookings Institution. They say principles are the fiscal stimulus should be timely, targeted and temporary. So first two principles are similar to the one highlighted by Mishkin. The difference is perhaps in the third point where fiscal stimulus should be temporary and monetary policy flexible and change its stance as per market conditions.

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