Chapter 11 – Monetary Policy and Debates Money and Banking – Michael Brandl ©2017 Cengage Learning

11-1a Goals of Monetary Policy Price level stability is one of the most important goals of monetary policy. The goal is to keep inflation and deflation from becoming a problem. Price level stability – How much “stability” is optimal? Money and Banking – Michael Brandl ©2017 Cengage Learning

11-2a High Employment Goal Should high employment be one of the goals of monetary policy? Think about all of the factors that go into determining the level of employment in an economy: the skill levels of the workforce, the derived demand of the output, the level of uncertainty of business, among others Keep in mind there are several types of unemployment. Frictional Structural Cyclical Money and Banking – Michael Brandl ©2017 Cengage Learning

11-2b Financial Market Stability: Interest Rates & Exchange Rates Stable interest rates would make business investment decisions easier because the cost of capital for firms would fluctuate less. Stable interest rates would increase the amount of durable goods households could purchase. Stable exchange rates would make it easier to price imports and exports. Should financial market stability be part of monetary policy? Money and Banking – Michael Brandl ©2017 Cengage Learning

11-3a Central Bank Independence Central banks are generally seen as being independent of the political process: They answer only indirectly to elected officials Another complaint about the Fed, and thus the need to limit the Fed’s independence, is that the Fed has gone soft on fighting inflation, accusing it of “debasing the currency” Would more political control over central banks make these powerful entities more answerable to the people and push the central bankers to do a better job controlling inflation? Money and Banking – Michael Brandl ©2017 Cengage Learning

11-3b Instruments & Targets Central banks have a major problem in the conduct of monetary policy because of lags. There are information lags Information lag Impact lag There is a delay between when the Fed changes policy and when that policy affects employment, output, and prices. The Fed has to think about how can it use its tools to affect policy instruments—those things the Fed can directly affect—and thus hit some targets with the intent of achieving its goals. Money and Banking – Michael Brandl ©2017 Cengage Learning

11-4a Taylor Rule and Inflation The Taylor Rule assumes that the Fed has a 2% “target rate of inflation” When real GDP equals potential GDP and inflation is at its target rate of 2 percent, the federal funds target rate should be 4%. A real federal funds rate of 2% = 4% nominal federal funds rate - 2% inflation rate Money and Banking – Michael Brandl ©2017 Cengage Learning

11-4b Taylor Rule and Output Gap The output gap is the percentage difference in the actual level of output and what the level of output would be if the economy were at full employment or the GDP at its potential. The Taylor Rule suggests the Fed should lower its target for the federal funds rate. Taylor Rule would imply that the target for the federal funds rate should be negative! Money and Banking – Michael Brandl ©2017 Cengage Learning

11-4c Mankiw Rule: An Alternative to the Taylor Rule “Mankiw Rule” uses the consumer price index core inflation rate over the previous 12 months and the seasonally adjusted unemployment rate. Federal funds rate = 8.5 + 1.4 (core inflation – unemployment) Money and Banking – Michael Brandl ©2017 Cengage Learning

11-5 Monetary Policy and the Crisis Joseph Stiglitz argues that monetary policy in the U.S. at the time of the 2007-2008 crisis focused on 6 generally accepted ideas: Price stability is a necessary and almost sufficient condition for economic stability There is no such thin as an asset bubble Even if there were a bubble, one can’t tell until after it breaks Even if the Fed realized there was a bubble, it didn’t have the tools to deal with the problem Even if the Fed had the tools to deal with the bubble, it should not use them It is better to clean up after the bubble breaks than to interfere in the market beforehand Money and Banking – Michael Brandl ©2017 Cengage Learning