Inflation and Monetary Policy (Romer, sections 11.1, 11.2, section 11.6 to 11.9) Inflation and Hyperinflation Term Structure of Interest Rates Control of Monetary Aggregates Interest-rate rules Why did π > π* : Dynamic-inconsistency and Seignorage The Costs of Inflation (Do-it your-self)

Inflation, Money Growth, and Interest Rates Money growth is crucial to the inflation process ΔL cannot explain sustain ΔP, but ΔM can. Empirical evidences (Figure 11.1 next slide, but caution on causality)

What are the effects (under RE) of an increase in the growth rate of money supply assuming constant values of: In this case, Δπ = Δi and Δr=0 (Fisher effect)

ln M t πe t i t t0

ln M/P t ln P t Consequently A monetary policy consistent with a permanent drop in inflation is (Sargent 1982): ln M t t0 However in practice, there is a liquidity effect (changes in r) due to incomplete price flexibility.

Monetary Policy and the Term Structure of Interest Rates Term structure of interest rates: Relationship between interest rates of different horizons The usual theory to explain the relationship is based on the arbitrage between bonds of different maturity. In the no uncertainty case, this implies: With uncertainty, the relationship gives information on expectations: This is the Crystal Ball of economists WEB page BC

Term Structure and Changes in Federal Reserve’s Fed Funds-rate Target Permanent ↑m →↑π in the LR, so ↑i LR and ↓i SR (liquidity effect) i ↑m R maturity i

Targeting Monetary Aggregates Friedman (1960) argued to control the stock of Moneys, the k-percent rule M=kPY Problems with money targeting: M1 can be targeted but is not linked to aggregate demand. M2 is linked to AD but cannot be controlled. Case Study Bank of Canada experiment from 1975 to 1982. Gradualism: BC was able to control M1 Initial success 1975-1977 . Inflation Picked up thereafter, experienced ended in 1982. Governor Gerald Bouey ‘We did not abandon M!, M1 abandoned us.

Sources Figures 1 and 2: C. Freedman (2000), Monetary Aggregates and Monetary Policy in the Twenty-First Century: Discussion. Boston Fed

Taylor rule The Taylor rule is: Taylor argues based on the Fed experience, that: Consequently, when output gap is zero and inflation is on target, The neutral nominal interest rate is 4%.

Issues in designing interest-rate rules Natural interest rate probably varies over time. Consequently the policy maker should adjust accordingly one for one the nominal interest rate to any changes in the real rate. Considerable uncertainty at any time regarding the real interest rate and the output gap. Straiger, Stock, and Watson (1997) show that a 95 % interval for natural rate of unemployment is around 2 percentage points. Hp filter not reliable for the last few quarters Uncertainty regarding the natural interest rate and the output gap implies smaller coefficient for the phi in the Taylor rule (The ones proposed by Taylor take account of this)

Forward-looking interest rate rule Clarida, Gali, and Gertler (2000) argue that the CB should not react to current or past values of inflation and output gap since they are not affect by the policy. Instead, the rule should be forward-looking (equation with the same caveat).

Dynamic Inconsistency of Low Inflation Monetary Policy Kydkand and Prescott (1977), Barro and Gordon (1983) Romer: « If expected π is low, so that the marginal cost of additional inflation is low, policymakers will pursue expansionary policies to push output temporarily above its normal level. But the public’s knowledge that policymakers have this incentive means that they will not in fact expect low inflation. The end results is that policymakers’ ability to pursue discretionary policy results in inflation without any increase in output.»

Lucas supply curve: Social welfare function quadratic: No uncertainty, policymaker chooses directly π.

Analysis First situation, binding commitment by the policy maker regarding low π before expected inflation determined. Thus, π expected = actual π and by 11.53 The π that minimizes 11.54 is π* Second situation, policymaker chooses π taken expectation of π as given. (π expected determined before Δm). Combining 11.53 and11.54, we get: From the first order condition we get:

π Equation 11.57 45o πe π* πeq

Imposing π = πe in 11.57, we get: Relatively general result Come from the knowledge of discretion available to policymaker rather the discretion by itself. Solution: monetary rule (rule versus discretion) Delegation of monetary policy to conservative policymaker (next graph)

π Delegation of monetary policy To conservative policymaker From 11.59 With a’>a 45o πe π* πeq

Read section 11.8 on empirical application

11.9 Seignorage and inflation To simplify the notation: Seignorage S is:

What happens to S when π changes? The first term is positive and decreases with π, the second is negative and proportional to π. We have a Laffer curve (for the inflation tax).

S According to Cagan, Sach and Larrain 1993, S* is about 10% of GDP. The stable equilibrium is π1. S* G π1 π2 π