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Interest and Prices: Foundations of a Theory of Monetary Policy
With the collapse of the Bretton Woods system, any pretense of a connection of the world's currencies to any real commodity has been abandoned. Yet since the 1980s, most central banks have abandoned money-growth targets as practical guidelines for monetary policy as well. How then can pure "fiat" currencies be managed so as to create confidence in the stability of national units of account?
Interest and Prices seeks to provide theoretical foundations for a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets. In such a world, effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing. Michael Woodford reexamines the foundations of monetary economics, and shows how interest-rate policy can be used to achieve an inflation target in the absence of either commodity backing or control of a monetary aggregate.
The book further shows how the tools of modern macroeconomic theory can be used to design an optimal inflation-targeting regime--one that balances stabilization goals with the pursuit of price stability in a way that is grounded in an explicit welfare analysis, and that takes account of the "New Classical" critique of traditional policy evaluation exercises. It thus argues that rule-based policymaking need not mean adherence to a rigid framework unrelated to stabilization objectives for the sake of credibility, while at the same time showing the advantages of rule-based over purely discretionary policymaking.
Interest and Prices seeks to provide theoretical foundations for a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets. In such a world, effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing. Michael Woodford reexamines the foundations of monetary economics, and shows how interest-rate policy can be used to achieve an inflation target in the absence of either commodity backing or control of a monetary aggregate.
The book further shows how the tools of modern macroeconomic theory can be used to design an optimal inflation-targeting regime--one that balances stabilization goals with the pursuit of price stability in a way that is grounded in an explicit welfare analysis, and that takes account of the "New Classical" critique of traditional policy evaluation exercises. It thus argues that rule-based policymaking need not mean adherence to a rigid framework unrelated to stabilization objectives for the sake of credibility, while at the same time showing the advantages of rule-based over purely discretionary policymaking.
808 pages, Hardcover
First published August 18, 2003
About the author
Michael Woodford
75 books4 followersMichael Woodford grew up in Liverpool, and worked for Olympus for 30 years, becoming CEO on October 1st 2011. He is 51 years of age, married to Nuncy, a Spanish national, and they have two children, Edward 18 and Isabel 16. He is a keen runner and enjoys sailing.
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Displaying 1 - 2 of 2 reviews
April 17, 2026
This is the foundational textbook on monetary policy theory, presenting the "New Neoclassical Synthesis" – the marriage of the RBC literature's long-run analysis (specifically the equilibrium real rate of interest under flexible prices) with the Keynesian short-run analysis of output under price stickiness. The synthesis provides the mechanism for monetary policy to steer the real rate toward the Wicksellian "natural rate." Woodford labels his framework "Neo-Wicksellian" in honor of Knut Wicksell's Geldzins und Gütepreise (1898, and hence the title), inheriting Wicksell's vision of using interest rate policy to anchor price stability.
A central piece of this framework is an interest-rate rule that operates without any need to track the money supply. Woodford exhaustively studies the optimality of this rule by first establishing a baseline model of the economy independent of monetary variables. This is justified by his famous "Cashless limit" – an abstraction where money exists only as a unit of account rather than an asset held by agents – proving that such a limit is a reliable approximation even for economies where money is still physically held.
With the short-term nominal interest rate as the primary tool, Woodford assesses the rule's optimality through several lenses. Regarding the choice between commitment and discretion, the analysis demonstrates the superiority of a "timeless perspective:" a transparent commitment that anchors private-sector expectations. This management of expectations is vital because Calvo-style price rigidity creates forward-looking firms whose current decisions depend on the perceived future policy path. Because the framework is built on micro-foundations, optimality is derived from welfare foundations. However, as is typical for this framework, the analysis assumes small aggregate shocks to allow for linearization, meaning the results are rooted in local analysis and determinacy. Beyond pure welfare, the derived rules are designed specifically to ensure the economy is not prone to the "sunspots" of indeterminacy.
The book explores various other dimensions: which price indices to target, variations in market structures, giving the reader a truly "never-ending" feeling (or just a good reference book). Yet, the exhaustive argumentation serves a singular purpose: to prove that monetary policy can be conducted conveniently and effectively without the inaccurate tracking of monetary aggregates. And so, the New-Keynesians lived happily, although locally, ever after.
Ultimately, this is the definitive build-up and discussion of the monetary policy framework of this millennium. Its logic still resonates at the research frontier and certainly remains the "Bible" for mortal central bank researchers.
A central piece of this framework is an interest-rate rule that operates without any need to track the money supply. Woodford exhaustively studies the optimality of this rule by first establishing a baseline model of the economy independent of monetary variables. This is justified by his famous "Cashless limit" – an abstraction where money exists only as a unit of account rather than an asset held by agents – proving that such a limit is a reliable approximation even for economies where money is still physically held.
With the short-term nominal interest rate as the primary tool, Woodford assesses the rule's optimality through several lenses. Regarding the choice between commitment and discretion, the analysis demonstrates the superiority of a "timeless perspective:" a transparent commitment that anchors private-sector expectations. This management of expectations is vital because Calvo-style price rigidity creates forward-looking firms whose current decisions depend on the perceived future policy path. Because the framework is built on micro-foundations, optimality is derived from welfare foundations. However, as is typical for this framework, the analysis assumes small aggregate shocks to allow for linearization, meaning the results are rooted in local analysis and determinacy. Beyond pure welfare, the derived rules are designed specifically to ensure the economy is not prone to the "sunspots" of indeterminacy.
The book explores various other dimensions: which price indices to target, variations in market structures, giving the reader a truly "never-ending" feeling (or just a good reference book). Yet, the exhaustive argumentation serves a singular purpose: to prove that monetary policy can be conducted conveniently and effectively without the inaccurate tracking of monetary aggregates. And so, the New-Keynesians lived happily, although locally, ever after.
Ultimately, this is the definitive build-up and discussion of the monetary policy framework of this millennium. Its logic still resonates at the research frontier and certainly remains the "Bible" for mortal central bank researchers.
July 28, 2011
Dense to say the least. Though I'm still wrapping my head around his arguments concerning sunspot equilibrium, I think his stance on imperfect competition is very accurate. Especially when one examines this through the prism of current market conditions.
Displaying 1 - 2 of 2 reviews