Monetary Policy: A Summing Up

The Optimal Inflation Rate 25-1 Table 25-1 Inflation Rates in the OECD, 1981-2000 1981 1985 1990 1995 2000 OECD average (%)* 10.5 6.6 6.2 5.2 2.5 Number of countries with inflation below 5%** 2 10 15 21 24 * Average of GDP deflator inflation rates, using GDPs at PPP prices as weights. **Out of 30 countries. Inflation has steadily gone down in rich countries since the early 1980s. The attempt to reduce it even further depends on the costs and benefits of inflation.

The Costs of Inflation Shoe-leather costs are the costs of making more trips to the bank in the presence of inflation. They reflect an increase in the opportunity cost of holding money. Tax distortions occur when tax rates do not increase automatically with inflation, a concept known as bracket creep. Income for purposes of taxation includes nominal interest payments, not real interest payments.

The Costs of Inflation Money illusion is the cost of inflation associated with the notion that people make systematic mistakes in assessing nominal versus real changes, leading people to make incorrect decisions. Inflation variability means that financial assets such as bonds, which promise fixed nominal payments in the future, become riskier.

The Benefits of Inflation Seignorage, or the revenues from money creation, allow the government to borrow less from the public, or to lower taxes. An economy with a higher average inflation rate has more scope to use monetary policy to fight a recession. The presence of inflation allows for downward real-wage adjustments more easily than when there is no inflation.

The Optimal Inflation Rate: The Current Debate Those who aim for small but positive inflation argue that some of the costs of positive inflation can be avoided, and the benefits are worth keeping. Those who aim for zero inflation argue that this amounts to price stability, which simplifies decisions and eliminates money illusion. Today, most central banks appear to be aiming for a low but positive inflation, between 2 and 4%.

The Design of Monetary Policy 25-2 The choice of an optimal inflation rate determines the rate of nominal money growth. The central bank may want to announce a target for nominal money growth, and make it clear how it would deviate from it to address short-run fluctuations. Until recently, this is how monetary policy has been conducted in most countries.

Money Growth and Inflation Revisited The design of monetary policy around nominal money growth is based on the assumption that a close relation between inflation and nominal money growth exists in the medium run. The problem is that this relation is not very tight.

M1 Growth and Inflation M1 Growth and Inflation: 10-year averages, 1970-2000 There is no tight relation between M1 growth and inflation, not even in the medium run.

From M1 to M2, M3, and Other Monetary Aggregates The relation between M1 growth and inflation is not tighter because of shifts in the demand for money. Many financial assets are very liquid, which makes them attractive as substitutes for money. However, these assets are not included in M1. When people reduce their bank account balances and move to money market funds, there is a negative shift in the demand for money.

From M1 to M2, M3, and Other Monetary Aggregates Measures that include not only money but other liquid assets are called monetary aggregates, under the name of M2, M3, and so on. In the United States, M2 is also called broad money. The central bank could choose M2 growth as target, however, The relation between M2 growth and inflation is not very tight either, and The central bank does not control M2.

M2 Growth Target Range and Realization M2 Growth and Inflation: 10-year averages, 1970-2000 While the relation between M2 growth and inflation is tighter than the relation between M1 growth and inflation, it is still not very tight.

M2 Growth Target Range and Realization M2 Growth, 1975-2000: Actual Growth Rate and Target Growth Range Actual M2 growth has ended out of the target range for 11 out of the last 25 years. Since the Fed had missed the target so much, the Fed has decided not to announce a target range for M2 after the year 2000.

Inflation Targeting and Interest Rate Rules Many central banks have defined as their primary, and sometimes exclusive goal, the achievement of a low inflation rate. This is known as inflation targeting. Inflation targeting would lead the central bank to act in such a way as to eliminate all deviations of output from the natural level of output.

Taylor’s Rule According to Taylor, since it is the interest rate that directly affects spending, the central bank should choose an interest rate rather than a rate of nominal money growth. If , then the central bank should set it equal to its target value, i*. and

Taylor’s Rule The higher the value of a, the more the central bank will increase the interest rate in response to inflation. The higher the value of b, the more the central bank will be willing to deviate from target inflation to keep unemployment close to the natural rate. In sum, these coefficients reflect how much the central bank cares about unemployment versus inflation.

Taylor’s Rule Taylor’s rule provides a way of thinking about monetary policy: once the central bank has chosen a target rate of inflation, it should try to achieve it by adjusting the nominal interest rate. This rule actually describes quite well the behavior of central banks in the past 15-20 years.

The Fed in Action 25-3 The mandate of the Federal Reserve System was most recently defined in the Humphrey-Hawkins Act, passed by Congress in 1978. For more information on how the Fed is organized, go to the Fed’s Web site: www.federalreserve.gov/

The Organization of the Fed The Federal Reserve System is composed of three parts: A set of 12 Federal Reserve Districts The Board of Governors The Federal Open Market Committee (FOMC) and the Open Market Desk.

The Instruments of Monetary Policy The equilibrium interest rate is the interest rate at which the supply (left side) and the demand (right side) for central bank money are equal. The money supply, H, refers to the monetary base. The demand for money is the sum of the demand for currency and the demand for reserves by banks (refer to chapter 4 for more detail).

Reserve Requirements Reserve requirements are the minimum amount of reserves that banks must hold in proportion to checkable deposits. By changing reserve requirements, the Fed effectively changes the demand for central bank money. This instrument of monetary policy is not widely used because banks may take drastic actions to increase their reserves, such as recalling some of the loans.

Lending to Banks The Fed can also lend to banks, thereby affecting the supply of central bank money. The set of conditions under which the Fed lends to banks is called discount policy. The Fed lends at a rate called the discount rate, through the discount window. Today, changes in the discount rate are used mostly as a signal to financial markets.

Open-Market Operations Open-market operations, the purchase and sale of government bonds in the open market, is the main instrument of U.S. monetary policy. It is convenient and flexible. When the Fed buys bonds, it pays for them by creating money, thereby increasing the money supply, H. When it sells bonds, it decreases H.

The Practice of Policy The most important monetary policy decisions are made at meetings of the FOMC. Fed staff prepares forecasts and simulations of the effects of different monetary policies on the economy, and identifies the major sources of uncertainty. The conduct of open-market operations between FOMC meetings is left to the Open Market Desk.

The Practice of Policy Does the Fed have an inflation target, or follow an interest rate rule? The answer is: we don’t know. The Fed chairman, Alan Greenspan, is renowned for his lack of transparency. The evidence strongly shows that the Fed has in fact an implicit inflation target of about 3%. It is also clear that the Fed adjusts the federal funds rate in response both to the inflation rate and to deviations of unemployment from the natural rate.

The Practice of Policy The Federal Funds Rate, 1987-2001 In 1990-1992, and again in 2001, the Fed dramatically decreased the federal funds rate to try to avoid a recession.

Key Terms shoe-leather costs, money illusion, liquid asset, monetary aggregates, broad money (M2), inflation targeting, Taylor’s rule, Humphrey-Hawkins Act, Federal Reserve Districts, Board of Governors, Federal Open Market Committee (FOMC), Open Market Desk, reserve requirements, discount policy, discount rate, discount window,