Part I of this book provided some data, basic statistical analysis, and a focused historical account to highlight the link between inflation-stabilizing policy (related to the Taylor principle) and IOCS. We also showed a trade-off between interest rate volatility and IOCS. Still, the prior analyses are correlations between economic activity and policy instruments. We know these patterns are not the same as specifying a model that can identify causal relations between inflation-stabilizing policy and IOCS.

In this chapter, and for all of Part II, we characterize monetary policy so that we can infer both the policymaker's objectives and strategy. In subsequent chapters, we solve this model in order to demonstrate a behavioral relation that links policy instrument response to changes (variability) in inflation and output. Here, we describe (but do not yet solve) a structural model that shows the aggregate consequences of policymakers who promote information coordination. Following convention, we use a simplified three-equation representation that includes a supply function, an IS function, and a Taylor rule (see Rotemberg and Woodford 1997, 1998; Romer 2000; and McCallum 2001b).

Price Level Adjustment

The aggregate supply function we use incorporates a natural rate constraint and is a standard lagged expectations, augmented Phillips curve. There are variants of this model that apply to information signaling (Lucas 1972, 1973), institutional rigidities (Gray 1976, 1978; Brunner et al. 1980, 1983), and two-period nominal or real contracts (Fischer 1977; Taylor 1979, 1980; Fuhrer and Moore 1995a, b).