The Role of Models in Modern Monetary Policy

Stefania Perrucci and David Vavra

The objective of most central banks is to maintain price stability while promoting stable economic growth and employment. To this end, central banks adopt a systematic approach, ie, a monetary policy regime, which typically differs from country to country. Since the early 1990s, inflation targeting (IT) has been part of the monetary policy regime of many central banks, contributing credibility to their efforts, and helping to keep inflation under control in many countries for the following two decades. In IT regimes, the main focus is on the interest rate/monetary policy instrument path that is consistent with keeping inflation within range, or bringing inflation back to target.

In this chapter, we examine the types of model central banks build, and how they operate them. Usually, central banks maintain a whole suite of models, referred to as a forecasting and policy analysis system (FPAS). These models have different capabilities, with statistical/empirical models typically employed for short-term analysis and structural/behavioural models used for longer-term horizons. We describe the different components of an FPAS, including the central core model, the models used to