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Chapter 16

The Conduct of
Monetary Policy:
Strategy and
Tactics

The Price Stability Goal and the


Nominal Anchor
Over 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
stability
Gives a metric of the price level

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The Price Stability Goal and the


Nominal Anchor
Nominal anchors are important because they
help to limit the time inconsistency
problem
Problem where monetary policy conducted on a
discretionary day-by-day basis leads to poor long
term outcomes
EX: New Years resolution

Policy makers may be tempted to pursue a


discretionary expansionary policy
but in the long run this will lead to higher prices
and inflation.
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The Price Stability Goal and the


Nominal Anchor
So how to nominal anchors solve this
problem?
They set rules that the monetary policy
maker must adhere to
If there is an inflation target of 5%, then
policymakers cannot drive inflation rates above
this with expansionary policy
Constrains irresponsible behavior

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Other Goals of Monetary Policy


Five other goals are continually mentioned
by central bank officials when they discuss
the objectives of monetary policy:

(1)
(2)
(3)
(4)

high employment and output stability


economic growth
stability of financial markets
interest-rate stability

Reduce uncertainty in large investments/purchases

(5) stability in foreign exchange markets


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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
one
There 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)
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A Note on High employment and


output stability
Thus the goal of high employment is the
natural rate of unemployment (the level
at full employment)
Historically around 5% in US, but upwards of 67% since housing crisis

Since employment corresponds to a level of


output, can also measure the natural rate by
looking at economic output
Potential output: the output produced at the
natural level of unemployment

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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?

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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.

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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?

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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.

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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 this
Ex: US Federal Reserve Bank

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Should Price Stability Be the


Primary Goal of Monetary Policy?
Price Stability as the Primary, LongRun Goal of Monetary Policy
Either 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

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

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5 Elements of Inflation Targeting


1. Public announcement of medium-term numerical
target for inflation
2. Institutional commitment to price stability as the
primary, long-run goal of monetary policy and a
commitment to achieve the inflation goal
3. Information-inclusive approach in which many
variables are used in making decisions
4. Increased transparency of the strategy
5. Increased accountability of the central bank

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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 significantly

Canada (1991)
Inflation decreased since then, some costs in term of
unemployment

United Kingdom (1992)


Inflation has been close to its target.
Growth has been strong and unemployment has been
decreasing.

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Inflation Targeting (contd)


Advantages
Does not rely on one variable to achieve target
Easily understood
Reduces potential of falling in time-inconsistency
trap
Stresses transparency and accountability

Disadvantages
Delayed signaling (effects of policies on inflation
may have lags)
Too much rigidity
Potential for increased output fluctuations
Low economic growth during disinflation
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Figure 1
Inflation Rates
and Inflation
Targets for New
Zealand,
Canada, and the
United Kingdom,
19802011

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The Federal Reserves Monetary


Policy Strategy
The 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 target
Monetary policy can take over a year to affect
output and two years to impact inflation
significantly
US thus acts sooner than later to prevent inflation, once
inflation hits its too late.

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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 strikes
Also known as just do it approach

The goal is to prevent inflation from getting


started.

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The Federal Reserves Monetary


Policy Strategy (contd)
Advantages
Uses many sources of information
Demonstrated success

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

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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

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Lessons for Monetary Policy Strategy


from the Global Financial Crisis
1. 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, precrisis)
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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 bubbles


Credit-driven bubbles
Subprime financial crisis

Bubbles driven solely by irrational exuberance

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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 exuberance
Bubbles 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

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Greenspan Doctrine: Why not to


burst asset-bubbles.
Nearly impossible to detect
Raising 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)
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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.

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Tactics: Choosing the Policy


Instrument
Tools
Open market operation
Reserve requirements
Discount rate

Policy instrument (operating instrument)


Reserve aggregates
Interest rates
May be linked to an intermediate target

Interest-rate and aggregate targets are


incompatible (must chose one or the other).

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Figure 2 Linkages Between Central Bank


Tools, Policy Instruments, Intermediate
Targets, and Goals of Monetary Policy

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Figure 3 Result of Targeting on


Nonborrowed Reserves

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Figure 4 Result of Targeting on


the Federal Funds Rate

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Criteria for Choosing the Policy


Instrument
Observability and Measurability
Controllability
Predictable effect on Goals

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Tactics: The Taylor Rule, NAIRU, and


the Phillips Curve
Federal funds rate target =
inflation rate equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
*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 gap


Stabilizing real output is an important concern
Output 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)

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Figure 5 The Taylor Rule for the


Federal Funds Rate, 19702011

Source: Federal Reserve; www.federalreserve.gov/releases and authors calculations.

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