Monetary policy ensures that nominal income,Nt = PtYt (6)follows an exogenous stochastic process. We refer to these shocks to Nt as "demand" shocks, while changes in productivity are "supply" shocks. We do not model the way in which monetary policy achieves the path for Nt, which may be directly via the money supply together with a cash‐in‐advance constraint in the consumer's problem, or via a nominal interest‐rate rule with a very large response to deviations of Nt from PtYt.
I hope this approach spreads.
P.S. Shouldn't this read that the interest rate rule responds strongly to deviations of PtYt from Nt*, where Nt* is the target? I was supposing the "exogenous stochastic process" is representing how well that works. The way they write here, it sounds like someone is supposed to respond strongly whenever the identity Nt = PtYt doesn't hold.
P.P.S. A nominal interest rate rule that strongly responds to deviations of nominal income from target sounds like something the Fed might do. Putting a cash in advance constraint into the consumer problem sounds like something a macroeconomist might do to a model. I find it grating.