THE THEORETICAL FOUNDATIONS OF CENTRAL BANK’S SEPARATION PRINCIPLE, THE RISING IMPORTANCE OF THE UNIT OF ACCOUNT AND THE NEED FOR A DYNAMIC MONETARY POLIC
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Abstract
The separation principle guides central banks’ mandates, giving priority to price over financial stability. The former requires specifying the conditions that make the monetary system determinate. Money must be above all a medium of exchange and monetary policy must be neutral with respect to distribution effects on income and expenditure, and on the holdings of financial assets. This implies that the inclusion of the financial sector is irrelevant or redundant to the aim of maintaining price stability. This view is exemplified by Neo-Walrasian monetary theory (NWMT) which is the basis of inflation targeting. Since the Global Financial Crisis (2008-2009), the growing recognition that monetary policy has major effects on financial conditions and the real economy has underscored the role of money as unit of account. This poses major challenges for the separation principle and its theoretical foundations. The paper proposes the adoption of a dynamic monetary policy framework as first step to address these limitations.
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