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THE THEORETICAL FRAMEWORK OF MONETARY POLICY REVISITED

 

Hiona Balfoussia

Bank of Greece

 

Sophocles N. Brissimis

Bank of Greece

 

Manthos D. Delis

City University

 

Abstract

The three-equation New-Keynesian model advocated by Woodford (2003) as a self-contained system on which to base monetary policy analysis is shown to be inconsistent in the sense that its long-run static equilibrium solution implies that the interest rate is determined from two of the system’s equations, while the price level is left undetermined. The inconsistency is remedied by replacing the Taylor rule with a standard money demand equation. The modified system is seen to possess the key properties of monetarist theory for the long run, i.e. monetary neutrality with respect to real output and the real interest rate and proportionality between money and prices. Both the modified and the original New-Keynesian models are estimated on US data and their dynamic properties are examined by impulse response analysis. Our research suggests that the economic and monetary analysis of the European Central Bank could be unified into a single framework.

 

JEL classification: E40, E47; E52, E58

Keywords: Monetary theory; Central banking; New-Keynesian model; Impulse response analysis

 

Acknowledgement: We are grateful to Hercules Voridis, Stephen Hall, George Hondroyiannis and Ifigeneia Skotida for valuable comments and suggestions. Any views expressed are only those of the authors and should not be attributed to the Bank of Greece.

 

Correspondence:

Sophocles N. Brissimis

Bank of Greece
21, E. Venizelos Ave.,
102 50 Athens, Greece

tel.  + 30 210 3202388

Email: sbrissimis@bankofgreece.gr


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