Issues in Monetary Policy

This chapter explains innovation and developments in an advanced monetary economy that adds to the many routes by which monetary policy influences financial assets and the real economy. The mechanism by which money influences the economy is through two principal routes. These are known as the ‘direct mechanism’ and the ‘indirect mechanism’. The impact of the indirect effect depends on how sharply interest rates and asset prices react to the initial monetary shock, the liquidity effect, and subsequently how fast interest rates and asset prices respond to expectations of future monetary policy. The chapter distinguishes between inflation volatility and inflation uncertainty. A credible price level targeting policy means that any deviation from the target results in a predictable movement back to the target, therefore lowering inflation uncertainty, reducing the inflation risk premium and creating higher growth through marginal investment.