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Title: Money in Monetary Policy Design under Uncertainty: The Two-Pillar Phillips Curve versus ECB-Style Cross-Checking

Author(s): GŁnter Beck and Volker Wieland

Publication Date: February 2007

Keyword(s): European Central Bank, monetary policy, monetary policy under uncertainty, money, Phillips curve and quantity theory

Programme Area(s): International Macroeconomics

Abstract: The European Central Bank has assigned a special role to money in its two pillar strategy and has received much criticism for this decision. In this paper, we explore possible justifications. The case against including money in the central bank's interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. Of course, if one allows for a direct effect of money on output or inflation as in the empirical 'two-pillar' Phillips curves estimated in some recent contributions, it would be optimal to include a measure of (long-run) money growth in the rule. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. Such misperceptions cause a bias in policy setting. We find that cross-checking and changing interest rates in response to sustained deviations of long-run money growth helps the central bank to overcome this bias. Our argument in favour of ECB-style cross-checking does not require direct effects of money on output or inflation.

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Bibliographic Reference

Beck, G and Wieland, V. 2007. 'Money in Monetary Policy Design under Uncertainty: The Two-Pillar Phillips Curve versus ECB-Style Cross-Checking'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=6098