Issues in Monetary Policy: The Relationship Between Money and the Financial Markets


Since the Bank of England was made independent in 1997, the conduct of monetary policy has been relatively uncontroversial. The debates between Keyneisans, monetarists and supporters of fixed exchange rate mechanisms now appear very distant.

Despite the apparent consensus there are many issues related to the conduct of monetary policy that are not yet settled and which will soon come to the fore. Is the current form of independence for the Bank of England appropriate? Should a central bank target inflation or the prices level? How does a central bank deal with asset price deflation? Should more account be taken of monetary aggregates? Should central banks target asset prices? What is the relationship between the money supply and asset price inflation? How should central banks ensure financial stability?

The IEA was at the forefront of changing the parameters of the debate surrounding monetary policy in the 1970s and 1980s. This text, brings together some of the leading authors in the field, including the current Governor of the Bank of England, to discuss current issues in monetary policy and the relationship between monetary policy and financial markets. It is appropriate for undergraduates and postgraduates in economics and finance as well as for practitioners in financial markets.

Kent Matthews is the Julian Hodge Professor of Banking and Finance at Cardiff University. He trained at the London School of Economics, Birkbeck College and Liverpool University and has held previous academic positions at Liverpool University, Liverpool Business School. He has held visiting posts at the Catholic University of Leuven Belgium, Humbolt University, Berlin and University ofWestern Ontario, Canada as well as professional posts at the National Institute of Economic & Social Research, the Bank of England and Lombard Street Research Ltd.

Philip Booth BA, PhD, FIA, FSS is Editorial and Programme Director at the Institute of Economic Affairs and Professor of Insurance and Risk Management at Cass Business School, City University. He has previously worked as a special advisor on financial stability issues for the Bank of England. Philip Booth is editor of the journal Economic Affairs and associate editor of the British Actuarial Journal. He is a Fellow of the Institute of Actuaries and of the Royal Statistical Society. Amongst previous books he has written are Investment Mathematics (Wiley), Modern Actuarial Theory and Practice (CRC/Chapman Hall) and The Way Out of the Pensions Quagmire (Institute of Economic Affairs). He teaches, researches and writes in the areas of finance, investment and social insurance.

List of Contributors.

1 Issues in Monetary Policy (Kent Matthews and Philip Booth).

1.1 Introduction.

1.2 The monetarist counter-revolution.

1.3 Practice ahead of theory.

1.4 The dangers of practice without theory.


2 Monetary Policy: Practice Ahead of Theory (Mervyn King).

2.1 Introduction.

2.2 What can monetary policy do?

2.3 Learning and its implication for monetary policy.

2.4 Inflation targeting as a framework which accommodates learning.

2.5 Conclusion.


3 Are the Structure and Responsibilities of the Bank of England Optimal and If Not, Does It Matter? (David B. Smith).

3.1 Introduction.

3.2 Current arrangements.

3.3 The conventional theoretical macro model (CTMM).

3.4 How the Bank’s main macro model constrained the monetary debate.

3.5 The new Bank of England quarterly model.

3.6 The monetarist case for a big central bank.

3.7 Lessons from Britain’s monetary history.

3.8 Main conclusions.

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4 Why Price-Level Targeting is better than Inflation Targeting (Andrew Lilico).

4.1 Introduction.

4.2 How do inflation targeting and price-level targeting differ?

4.3 What is there to gain from long-term price stability?

4.4 Inflation volatility is not same thing as inflation uncertainty.

4.5 Price-level targeting generates its own credibility.

4.6 Price-level targeting is self-regulating.

4.7 Price-level targeting offers escape from a low-employment equilibrium.

4.8 The ‘costs’ of price-level targeting have corresponding benefits.

4.9 Price-level targeting vs. average inflation targeting.

4.10 The history of price-level targeting.

4.11 Conclusion.


5 A Price Targeting Regime Compared to a Non Price Targeting Regime. Is Price Stability a Good Idea? (Keith Pilbeam).

5.1 Introduction.

5.2 The ultimate objective of economic policy.

5.3 Modeling economic shocks.

5.4 The model.

5.5 Determining Equilibrium.

5.6 A money demand shock.

5.7 Aggregate demand shock.

5.8 An aggregate supply shock.

5.9 The search for an indicator.

5.10 Conclusions.


6 Optimal Monetary Policy with Endogenous Contracts: Is there a Case for Price-Level Targeting and Money Supply Control? (Patrick Minford).

6.1 Introduction.

6.2 Considerations in designing monetary policy arrangements.

6.3 Monetary policy: Is inflation targeting the best we can do?

6.4 Interest rate control – what does it do?

6.5 Money supply targeting and feedback rules – a stochastic simulation analysis.

6.6 Conclusions.

Annex: The representative agent model (RAM).


7 Forecasting Inflation: The Inflation ‘Fan Charts’ (Kevin Dowd).

7.1 Inflation forecasting.

7.2 The inflation fan charts.

7.3 The Bank’s forecast inflation density function.

7.4 Evaluating the Bank’s inflation forecasts.

7.5 Conclusions.

Annex: The two-piece normal density function.


8 Asset Prices, Financial Stability, and the Role of the Central Bank (Forrest Capie and Geoffrey Wood).

8.1 Introduction.

8.2 What is price stability?

8.3 Financial stability.

8.4 The lender of last resort.

8.5 Do asset prices matter?

8.6 Should institutions be propped up?

8.7 Financial benefits of monetary stability.

8.8 Conclusions.


9 Money, Asset Prices and the Boom-Bust Cycles in the UK: An Analysis of the Transmission Mechanism from Money to Macro-Economic Outcomes (Tim Congdon).

9.1 Introduction.

9.2 Traditional accounts of the transmission mechanism.

9.3 Asset prices in the traditional accounts.

9.4 The ownership of capital assets in the UK.

9.5 Asset prices and economic activity.

9.6 Conclusion: Money and asset prices in the transmission mechanism.

Annex: Econometric analysis of one type of real balance effect.


10 Money, Bubbles and Crashes: Should a Central Bank Target Asset Prices? (Gordon T. Pepper with Michael J. Oliver).

10.1 Introduction.

Part A: The monetary theory of bubbles and crashes.

10.2 Types of traders in securities.

10.3 Extrapolative expectations.

10.4 Debt-deflation.

Part B: Should a central bank target asset prices?

10.5 Preventing financial Bubbles.

10.6 Conclusions – an answer and a question.

Annex: Disequilibrium.


11 Monetary Policy and the Bank of Japan (John Greenwood).

11.1 Introduction.

11.2 Japan’s golden era in monetary policy, 1975–85.

11.3 How monetary policy went off the rails, 1985–89.

11.4 The bursting of the bubble, 1989–91.

11.5 Assessment of policy responses.

11.6 Monetary policy – deliberate yen depreciation.

11.7 Monetary policy – government borrowing from the banks.

11.8 Restructuring policies.

11.9 Conclusion.


Appendix 1: Unemployment versus Inflation? An Evaluation of the Phillips Curve (Milton Friedman).

Appendix 2: The Counter-Revolution in Monetary Theory (Milton Friedman).