A consensus now exists that central banks, which possess a monopoly over the creation of fiat money (the monetary base), control trend inflation. But how do they exercise this control, especially given that their use of the interest rate as the policy instrument renders money endogenous (determined by market forces)? This paper considers two alternatives. First, central banks control inflation through the way that they manipulate the unemployment rate (subject to a trade-off between changes in inflation and the amount of excess unemployment as summarized in a Phillips curve). Second, and alternatively, central banks control inflation by following consistent procedures that combine two characteristics. Through their consistency, these procedures provide for a nominal anchor by causing the public to expect low trend inflation that is stable in the sense of being unaffected by inflation and recession shocks. Also, they allow the price system to work in the sense of allowing market forces to determine real variables such as the unemployment rate.
Our Research Focus: Inflation and Monetary Policy
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