Monetary PolicyMonetary Policy

The Optimal Inflation Rate?The Optimal Inflation Rate?

Inflation has steadily gone down in rich Inflation has steadily gone down in rich countries since the early 1980s.countries since the early 1980s.

Should inflation be reduced even further?Should inflation be reduced even further?

Inflation Rates in the OECD, 1981-2000Inflation Rates in the OECD, 1981-200019811981 19851985 19901990 19951995 20002000

OECD average (%)OECD average (%) 10.510.5 6.66.6 6.26.2 5.25.2 2.52.5

Number of countries Number of countries with inflation below 5%with inflation below 5% 22 1010 1515 2121 2424

The Costs of InflationThe Costs of Inflation

Shoe-leather costsShoe-leather costs are the costs of making are the costs of making more trips to the bank. more trips to the bank.

Tax distortionsTax distortions occur when tax rates do not occur when tax rates do not increase automatically (bracket creep).increase automatically (bracket creep).

Money illusionMoney illusion: people make systematic : people make systematic mistakes in assessing nominal versus real mistakes in assessing nominal versus real changes.changes.

Inflation variabilityInflation variability: financial assets such as : financial assets such as bonds, which promise fixed nominal payments bonds, which promise fixed nominal payments in the future, become riskier.in the future, become riskier.

The Benefits of InflationThe Benefits of Inflation

SeignorageSeignorage, or the revenues from money , or the revenues from money creation, allow the government to borrow less creation, allow the government to borrow less from the public, or to lower taxes.from the public, or to lower taxes. Seignorage income for the U.S.Seignorage income for the U.S.

The presence of inflation allows for The presence of inflation allows for downward downward real-wage adjustmentsreal-wage adjustments more easily than when more easily than when there is no inflation.there is no inflation.

The Optimal Inflation Rate:The Optimal Inflation Rate:The Current DebateThe Current Debate

Those who aim for Those who aim for small but positive inflationsmall but positive inflation argue that some of the costs of positive inflation argue that some of the costs of positive inflation can be avoided, and the benefits are worth can be avoided, and the benefits are worth keeping.keeping.

Those who aim for Those who aim for zero inflationzero inflation argue that this argue that this amounts to price stability, which simplifies amounts to price stability, which simplifies decisions and eliminates money illusion.decisions and eliminates money illusion.

Today, most central banks appear to be aiming Today, most central banks appear to be aiming for a low but positive inflation, between 2 and for a low but positive inflation, between 2 and 4%.4%.

The importance of ideologyThe importance of ideology(Republicans and Democrats)(Republicans and Democrats)

Politics continued…Politics continued…

Official Goals of the FedOfficial Goals of the Fed

Promote Maximum EmploymentPromote Maximum Employment Maintain Stable PricesMaintain Stable Prices Achieve Moderate Long-Term Interest Achieve Moderate Long-Term Interest

RatesRates

The Design of Monetary Policy: The Design of Monetary Policy: Money GrowthMoney Growth

The choice of an optimal inflation rate The choice of an optimal inflation rate determines the rate of nominal money determines the rate of nominal money growth.growth.

g gm y

The central bank may want to announce a The central bank may want to announce a target for nominal money growth, and make it target for nominal money growth, and make it clear how it would deviate from it to address clear how it would deviate from it to address short-run fluctuations.short-run fluctuations.

Until recently, this is how monetary policy has Until recently, this is how monetary policy has been conducted in most countries.been conducted in most countries.

Money Growth and Inflation RevisitedMoney Growth and Inflation Revisited

The design of monetary policy around The design of monetary policy around nominal money growth is based on the nominal money growth is based on the assumption that a close relation between assumption that a close relation between inflation and nominal money growth exists inflation and nominal money growth exists in the medium run.in the medium run.

The problem is that this relation is not very The problem is that this relation is not very tight.tight.

M1 Growth and InflationM1 Growth and Inflation

M1 Growth and M1 Growth and Inflation: Inflation: 10-year averages10-year averages1970-20001970-2000

The Design of Monetary Policy: The Design of Monetary Policy: Inflation TargetingInflation Targeting

Many central banks have defined as their Many central banks have defined as their primary, and sometimes exclusive goal, primary, and sometimes exclusive goal, the achievement of a low inflation rate.the achievement of a low inflation rate.

Inflation targeting would lead the central Inflation targeting would lead the central bank to act in such a way as to eliminate bank to act in such a way as to eliminate all deviations of output from the natural all deviations of output from the natural level of output.level of output.

, then the central , then the central bank should set bank should set iitt equal to its target value, equal to its target value, ii*.*.

The Design of Monetary Policy: The Design of Monetary Policy: Interest Rate TargetingInterest Rate Targeting

Taylor’s Rule: According to Taylor, since it is the Taylor’s Rule: According to Taylor, since it is the interest rate that directly affects spending, the interest rate that directly affects spending, the central bank should choose an interest rate central bank should choose an interest rate rather than a rate of nominal money growth.rather than a rate of nominal money growth.

π π* e

t t t ni i a( ) b( u u )= + - - -

If If 1π πt t-= u ut nandand

Taylor’s RuleTaylor’s Rule

The higher the value of The higher the value of aa, the more the central , the more the central bank will increase the interest rate in response to bank will increase the interest rate in response to inflation.inflation.

The higher the value of The higher the value of bb, the more the central , the more the central bank will be willing to deviate from target inflation bank will be willing to deviate from target inflation to keep unemployment close to the natural rate.to keep unemployment close to the natural rate.

In sum, these coefficients reflect how much the In sum, these coefficients reflect how much the central bank cares about unemployment versus central bank cares about unemployment versus inflation.inflation.

π π* e

t t t ni i a( ) b( u u )= + - - -

Taylor’s RuleTaylor’s Rule

Taylor’s rule provides a way of thinking Taylor’s rule provides a way of thinking about monetary policy: once the central about monetary policy: once the central bank has chosen a target rate of inflation, bank has chosen a target rate of inflation, it should try to achieve it by adjusting the it should try to achieve it by adjusting the nominal interest rate.nominal interest rate.

This rule actually describes quite well the This rule actually describes quite well the behavior of many central banks in the behavior of many central banks in the past 15-20 years.past 15-20 years.

π π* e

t t t ni i a( ) b( u u )= + - - -

The Fed and the Interest RateThe Fed and the Interest Rate

The Organization of the FedThe Organization of the Fed

The Federal Reserve System is composed The Federal Reserve System is composed of three parts:of three parts: A set of 12 A set of 12 Federal Reserve DistrictsFederal Reserve Districts The The Board of Governors (7 members)Board of Governors (7 members) The The Federal Open Market Committee Federal Open Market Committee

(FOMC)(FOMC)..

The Fed’s DistrictsThe Fed’s Districts

The Instruments of Monetary The Instruments of Monetary PolicyPolicy

The equilibrium interest rate is the interest The equilibrium interest rate is the interest rate at which the supply and the demand rate at which the supply and the demand for central bank money are equal.for central bank money are equal.

The money supply, refers to the monetary The money supply, refers to the monetary base. base.

The demand for money is the sum of the The demand for money is the sum of the demand for currency and the demand for demand for currency and the demand for reserves by banks.reserves by banks.

1. Reserve Requirements1. Reserve Requirements

Reserve requirementsReserve requirements are the minimum are the minimum amount of reserves that banks must hold in amount of reserves that banks must hold in proportion to checkable deposits.proportion to checkable deposits.

By changing reserve requirements, the Fed By changing reserve requirements, the Fed effectively changes the demand for central bank effectively changes the demand for central bank money.money.

This instrument of monetary policy is not widely This instrument of monetary policy is not widely used because banks may take drastic actions to used because banks may take drastic actions to increase their reserves, such as recalling some increase their reserves, such as recalling some of the loans.of the loans.

2. Lending to Banks2. Lending to Banks

The Fed can also lend to banks, thereby The Fed can also lend to banks, thereby affecting the supply of central bank money.affecting the supply of central bank money.

The set of conditions under which the Fed The set of conditions under which the Fed lends to banks is called lends to banks is called discount policydiscount policy. . The Fed lends at a rate called the The Fed lends at a rate called the discount discount raterate, through the , through the discount windowdiscount window..

Today, changes in the discount rate are used Today, changes in the discount rate are used mostly as a signal to financial markets.mostly as a signal to financial markets.

3. Open-Market Operations3. Open-Market Operations

Open-market operations, the purchase Open-market operations, the purchase and sale of government bonds in the and sale of government bonds in the open market, is the main instrument of open market, is the main instrument of U.S. monetary policy. It is convenient U.S. monetary policy. It is convenient and flexible.and flexible.

When the Fed buys bonds, it pays for When the Fed buys bonds, it pays for them by creating money, thereby them by creating money, thereby increasing the money supply, increasing the money supply, HH. When it . When it sells bonds, it decreases sells bonds, it decreases HH..

The Fed can pursue expansionary The Fed can pursue expansionary monetary policy by…monetary policy by…

……open market purchases of bonds.open market purchases of bonds.

oror

……reducing the discount rate.reducing the discount rate.

oror

……reducing banks’ reserve requirement.reducing banks’ reserve requirement.

All of these will result, in the short run, in the All of these will result, in the short run, in the LM curve shifting to the right.LM curve shifting to the right.

The Practice of PolicyThe Practice of Policy

The most important monetary policy decisions The most important monetary policy decisions are made at meetings of the FOMC.are made at meetings of the FOMC.

Fed staff prepares forecasts and simulations of Fed staff prepares forecasts and simulations of the effects of different monetary policies on the the effects of different monetary policies on the economy, and identifies the major sources of economy, and identifies the major sources of uncertainty.uncertainty.

The conduct of open-market operations between The conduct of open-market operations between FOMC meetings is left to the Open Market Desk.FOMC meetings is left to the Open Market Desk.

The Practice of PolicyThe Practice of Policy Does the Fed have a money growth target, Does the Fed have a money growth target,

an inflation target, or follow an interest rate an inflation target, or follow an interest rate rule? rule?

The answer: we don’t know. The answer: we don’t know.

The Fed and the Output GapThe Fed and the Output Gap