CH16.ppt

Chapter 16The Conduct of Monetary Policy: Strategy and Tactics

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The Price Stability Goal and the Nominal AnchorOver the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy.

The role of a nominal anchor: a nominal variable such as the inflation rate or the money supply, which ties down the price level to achieve price stabilityGives a metric of the price level


The Price Stability Goal and the Nominal AnchorNominal anchors are important because they help to limit the time inconsistency problemProblem where monetary policy conducted on a discretionary day-by-day basis leads to poor long term outcomesEX: New Years resolutionPolicy makers may be tempted to pursue a discretionary expansionary policy but in the long run this will lead to higher prices and inflation.


The Price Stability Goal and the Nominal AnchorSo how to nominal anchors solve this problem?They set rules that the monetary policy maker must adhere toIf there is an inflation target of 5%, then policymakers cannot drive inflation rates above this with expansionary policyConstrains irresponsible behavior


Other Goals of Monetary PolicyFive other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy:

(1) high employment and output stability(2) economic growth(3) stability of financial markets(4) interest-rate stabilityReduce uncertainty in large investments/purchases(5) stability in foreign exchange markets


A Note on High employment and output stability The Fed DOES NOT TARGET AN UNEMPLOYMENT RATE OF 0%Target Full Employment (demand for labor equals supply of labor) all those who want a job have oneThere will always be frictional unemployment (a good thing)There will always be structural unemployment (a terrible thing)There may or may not be cyclical unemployment (the only kind monetary policy can affect)


A Note on High employment and output stabilityThus the goal of high employment is the natural rate of unemployment (the level at full employment)Historically around 5% in US, but upwards of 6-7% since housing crisisSince employment corresponds to a level of output, can also measure the natural rate by looking at economic outputPotential output: the output produced at the natural level of unemployment


Should Price Stability Be the Primary Goal of Monetary Policy?QUESTION: Should price stability be the primary goal of monetary policy?It depends

QUESTION: Is there an inconsistency between the goal of price stability and high employment/output in the long run?


Should Price Stability Be the Primary Goal of Monetary Policy?

EX: Is there an inconsistency between the goal of price stability and high employment/output in the long run?No, inflation does not lower or increase the natural rate of unemployment in the long run.i.e. no long run tradeoff between inflation and unemployment, so no inconsistency by keeping prices stable.


Should Price Stability Be the Primary Goal of Monetary Policy?Question: Is there an inconsistency between the goal of price stability and high employment/output in the short run?


Should Price Stability Be the Primary Goal of Monetary Policy?

Question: Is there an inconsistency between the goal of price stability and high employment/output in the short run?Yes, suppose the economy is in an expansionary phase (unemployment falling, output rising)Wages and prices will rise, increasing inflation (the economy begins to overheat)To pursue price stability, Fed increases interest rates, causing output to fall and increase interest rate stability.How is this conflict resolved? We look to policies enacted by nations for answers.


Should Price Stability Be the Primary Goal of Monetary Policy?Hierarchical Versus Dual Mandates:

hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued ex: European Central Bank, Bank of England, Bank of Canada, Reserve Bank of New Zealand

dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability)Recall interest rates will be high if prices are high and the Fed wants to avoid thisEx: US Federal Reserve Bank


Should Price Stability Be the Primary Goal of Monetary Policy?Price Stability as the Primary, Long-Run Goal of Monetary PolicyEither type of mandate is acceptable as long as it operates to make price stability the primary goal in the long run, but not the short run


Inflation TargetingSince price stability should be the primary long run goal, central banks often use a practice known as inflation targetingLiterally targeting and maintaining a set level of inflationRemember some inflation is good (will happen naturally as an economy grows), however too much is problematic


5 Elements of Inflation TargetingPublic announcement of medium-term numerical target for inflationInstitutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goalInformation-inclusive approach in which many variables are used in making decisionsIncreased transparency of the strategyIncreased accountability of the central bank


Inflation Targeting (contd)New Zealand (effective in 1990)Inflation was brought down and remained within the target most of the time. Growth has generally been high and unemployment has come down significantlyCanada (1991)Inflation decreased since then, some costs in term of unemploymentUnited Kingdom (1992)Inflation has been close to its target.Growth has been strong and unemployment has been decreasing.


Inflation Targeting (contd)AdvantagesDoes not rely on one variable to achieve targetEasily understoodReduces potential of falling in time-inconsistency trapStresses transparency and accountabilityDisadvantagesDelayed signaling (effects of policies on inflation may have lags)Too much rigidityPotential for increased output fluctuations Low economic growth during disinflation


Figure 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 19802011


The Federal Reserves Monetary Policy StrategyThe United States has achieved excellent macroeconomic performance (including low and stable inflation) until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation targetMonetary policy can take over a year to affect output and two years to impact inflation significantlyUS thus acts sooner than later to prevent inflation, once inflation hits its too late.


The Federal Reserves Monetary Policy Strategy (contd)There is no explicit nominal anchor in the form of an overriding concern for the Fed.Forward looking behavior and periodic preemptive strikesAlso known as just do it approachThe goal is to prevent inflation from getting started.


The Federal Reserves Monetary Policy Strategy (contd)AdvantagesUses many sources of informationDemonstrated success

DisadvantagesLack of accountability (Fed is not transparent in its intentions for future inflation, keeps business uncertain)Inconsistent with democratic principlesIf Fed is subject to political pressures (ex: presidential appointments) they could follow political agendasFed is largely considered independent however


The Federal Reserves Monetary Policy Strategy (contd)Advantages of the Feds Just Do It Approach: forward-looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby ameliorating the time-inconsistency problem

Disadvantages of the Feds Just Do It Approach:lack of transparency; strong dependence on the preferences, skills, and trustworthiness of the individuals in charge of the central bank


Lessons for Monetary Policy Strategy from the Global Financial Crisis1. Developments in the financial sector have a far greater impact on economic activity than was earlier realized

2. The zero-lower-bound on interest rates can be a serious problem

3. The cost of cleaning up after a financial crisis is very high

4. Price and output stability do not ensure financial stability (inflation and output were very stable, pre-crisis)


Lessons for Monetary Policy Strategy from the Global Financial Crisis (contd)How should Central banks respond to asset price bubbles?Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst.Types of asset-price bubblesCredit-driven bubblesSubprime financial crisisBubbles driven solely by irrational exuberance


Lessons for Monetary Policy Strategy from the Global Financial Crisis (contd)Should central banks respond to bubbles?Strong argument for not responding to bubbles driven by irrational exuberanceBubbles are easier to identify when asset prices and credit are increasing rapidly at the same time. Greenspan Doctrine: Monetary policy should not be used to prick bubbles.Lean vs. Clean debate


Greenspan Doctrine: Why not to burst asset-bubbles.Nearly impossible to detectRaising interest rates would have little effect (one would expect high rates of return on bubble-driven assets)Many assets exist and the bubble may be sector specific. Monetary policy is a blunt tool that may harm healthy sectors.High interest rates lead to layoffs and output reduction (exactly what youre trying to avoid)If Fed action is swift after bubble bursts, they can clean it up with relatively minimal damage (ex: stock market bubbles of 1987 and 2000)


Lessons for Monetary Policy Strategy from the Global Financial Crisis (contd)Macropudential policy: regulatory policy to affect what is happening in credit markets in the aggregate.

Monetary policy: Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction.


Tactics: Choosing the Policy InstrumentToolsOpen market operationReserve requirementsDiscount ratePolicy instrument (operating instrument)Reserve aggregatesInterest ratesMay be linked to an intermediate targetInterest-rate and aggregate targets are incompatible (must chose one or the other).


Figure 2 Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets, and Goals of Monetary Policy


Figure 3 Result of Targeting on Nonborrowed Reserves


Figure 4 Result of Targeting on the Federal Funds Rate


Criteria for Choosing the Policy InstrumentObservability and MeasurabilityControllabilityPredictable effect on Goals


Tactics: The Taylor Rule, NAIRU, and the Phillips Curve*equilibrium rate is that consistent w/full employment*inflation gap: actual target inflation*output gap: % deviation of GDP from natural rate level of GDP

An inflation gap and an output gapStabilizing real output is an important concernOutput gap is an indicator of future inflation as shown by Phillips curve (shows inflation and unemployment)NAIRU (nonaccelerating inflation rate of unemployment)Rate of unemployment at which there is no tendency for inflation to change (ex: if unemp. Above NAIRU, inflation will decrease)


Figure 5 The Taylor Rule for the Federal Funds Rate, 19702011Source: Federal Reserve; www.federalreserve.gov/releases and authors calculations.

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CH16.ppt