prem_ppt_ch18.ppt

Chapter
Eighteen
Rules for
Monetary Policy

Copyright © Houghton Mifflin Company. All rights reserved. 18 | 2
• If monetary policy were predictable,
people and businesses could make better
informed decisions
• A rule for monetary policy is a
systematic setting of policy according to a
formula
• If monetary policy is not set by rule, it is
said to be set by discretion
– May ease policy (increasing money supply) or
tighten (decreasing money supply) policy
Rules for Monetary Policy

• Expectations trap: occurs when
policymakers must increase inflation in
response to an increase in the expected
inflation rate
• Example: People expect higher inflation,
so wages rise; if the Fed does not
increase inflation, real wages are too high,
so unemployment then rises
• But why do people expect higher inflation?
The Expectations Trap

The Expectations Trap (cont’d)
• Why do people expect
higher inflation?
• Fed is easing monetary
policy before an election
to aid the incumbent
• Potential output growth
has slowed without
policymakers realizing it,
causing them to
erroneously think the
output gap is negative

• A more subtle reason to explain why people
expect the Fed to ease monetary policy
• Time inconsistency is the is the difficulty that
arises when a policy is chosen at date t, then
people make a choice based on that policy, and
then policymakers have incentive to change
policy at a different date
• Example: one-time gains from fooling people
• If people anticipate a time-inconsistent incentive,
they will ignore the first policy
Time Inconsistency

• Central banks need credibility if they want
to avoid time-inconsistent policies
• Ways the Fed could achieve credibility
– Its only goal is low inflation
– Fed is (even more) independent from politics
– Chooses conservative policymakers
– Establishing a good reputation over time
• If the Fed cannot achieve credibility, the
alternative to time inconsistency is
commitment, or a monetary policy rule
Credibility

• Following a rule “ties the hands” of the
central bank
• But if the bank itself sets the rule, it is
difficult to truly tie their hands
• Example: Argentine currency board
pegging the peso to the dollar…Such a
policy actually eliminates monetary policy
• Discretion is the ultimate source of time
inconsistency
Commitment

• The first type of rule proposed by
monetarists in 1960s was the money-
growth rule
• A money growth rule focuses only in the
growth rate of money in the long run,
ignoring short run fluctuations
• Example: money growth = 3% every year
• Such a rule is based on the equation of
exchange
Money-Growth Rules

• The equation of exchange is based on
idea that the money in circulation must be
used a certain number of times to support
a given amount of spending
M × V = P × Y
• Velocity = number of times the average
dollar is spent on final goods and services
The Equation of Exchange

%M + % V = %P + %Y
=  + %Y
Money growth + velocity growth = inflation rate + output growth
• Monetarists believe velocity is stable or at least
predictable
%ΔM = πT + %ΔY* - %ΔVe
πT = inflation target
%ΔY* = growth rate of potential output
%ΔVe = expected growth rate of velocity
Money-Growth Targets

• Financial innovations sometimes alter the
relationship between money and other
variables, such as the introduction of
interest-bearing checking accounts
• As a result, velocity has become unstable
in the 1980s and 1990s.
• Economists had been paying more
attention to M2 than to M1
Instability of Money-Growth Rule

M1 growth and velocity changed drastically beginning the 1980s,
without leading to increased inflation
Instability of Money-Growth Rule (cont’d)
Figure 18.1 M1 Growth, M1 Velocity Growth, and the Inflation Rate

M2 growth rate trended up in the 1990s, also without leading to
increased inflation
Instability of Money-Growth Rule (cont’d)
Figure 18.2 M2 Growth, M2 Velocity Growth, and the Inflation Rate

• Activist rules: allow for changes in
monetary policy in response to business
cycle fluctuations
• Non-activist rules: keeping monetary
policy unchanged in response to business
cycle fluctuations
– Monetarists believed in non-activist rules
• Policymakers have sought a rule that was
simple but that allowed for some activism
Activist Versus Non-Activist Rules

• The Taylor Rule suggests that monetary policy
sets the federal funds rate in response to
deviations in real output and inflation from their
targets
i = r* + π + (w1 × Y~) + (w2 × π~)
• Thus the nominal ffr is increased if positive
output or inflation gaps exist, and vice versa
• Intuition: set funds rate at long-run average;
deviate for gaps
The Taylor Rule

The Taylor Rule (cont’d)

• It is activist, so liked by Keynesians, and a
rule, so liked by classical economists
• Potential difficulties
– Hard to know potential output (hence output
gap) in real time
– Optimal weights depend on the model used
– Equilibrium real interest rate may not be
historical average
– Data revisions affect rule settings

A policymaker following the Taylor Rule would have wanted tighter policy in the
50s-70s and early 2000s, and easier policy in the 80s and 90s
Figure 18.3a Actual Federal Funds Rate and the Taylor Rule Recommendation

• Inflation targeting is a system in which a
central bank tries to achieve an explicit target for
inflation within a given time period
• Steps in inflation targeting
– picks a target band for the inflation rate
– gets the inflation rate within the band within a
specified period
– maintains the inflation rate within the band thereafter
Inflation Targeting

• New Zealand was the first country to use
inflation targeting
– 1990: target 3 to 5%
– 1991: target 2.5 to 4.5%
– 1992: target 1.5 to 3.5%
– Now: target 0 to 3%
• Failure to hit targets could lead to
dismissal of central bank governor
Inflation Targeting (cont’d)

Advantages of Inflation Targeting
1. Provides credibility; makes goals of central
bank transparent
2. Inflation report keeps public informed of
progress, removes some time inconsistency
problems
3. Reduces uncertainty faced by investors
about short-term interest rates

Disadvantages of Inflation Targeting
1. Reduces flexibility of the central bank,
especially because central bank also cares
about output in the short run
2. Requires the use of inflation forecasts,
which may not be accurate
3. Necessitates difficult choices on how quickly
to reduce inflation post-shock
• Some countries allow target to be
deviated from in times of recession

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