Chapter 23: Learning Objectives Targets vs. Instruments of Monetary Policy Understanding Monetary Policy: Interest Rate vs. Money Supply Control Central Bank Performance: Political Business Cycles & Autonomy Evaluating the Stance of Monetary Policy: the Monetary Conditions Index

Targets and Instruments of Monetary Policy The problem of monetary policy formulation is one of understanding the relationship between operating instruments, intermediate targets, and final targets OPERATING INSTRUMENTS are the tools of monetary policy under the control of a central bank INTERMEDIATE TARGETS represent economic variables which react quickly and predictably to changes in the operating instruments FINAL TARGETS are the economic variables which permit an assessment of monetary policy actions

Characterizing Monetary Policy Actions The choice in implementing monetary policy is usually between changing the money supply (M1) or a short-term interest rate (O/N rate) Assume a money demand model of the kind introduced in chapter 12 Introduce some uncertainty into the process by allowing some error in fluctuations around the variables of interest (interest rate and M1)

What Policies are Interesting to Look at? Money supply targeting (FIGURE 23.3) leads to more interest rate variability than money supply variability. Was tried in the 1980s with poor results Interest rate pegging (FIGURE 23.4) leads to money supply variability but less interest rate variability. Sometimes referred to as interest rate smoothing Which policy is better? Assuming that less variability is better and markets are more affected by interest rate changes then smoothing of interest rates seems the best option

Figure Instruments Control: The Basic Relationships A.Demand for Money M d t = P t f(y t,R t ) + u t M d (u < 0) R M M d (u = 0) M d (u > 0)

Figure Instruments Control: The Basic Relationships B. Money Supply; M s t = I(R t ) Base t + vt M s (v < 0) R M M s (v = 0) M s (v > 0)

Figure Money Supply Targeting A.Money Supply Targeting When the Slope of Money Demand Changes M s min R M M s max Md0Md0 R min R max Md1Md1 R’ max

Figure Money Supply Targeting B. Money Supply Targeting and Money Demand Uncertainty M d min R M M d max Ms0Ms0 R min R max

R min M1M1 M s min M d min M d max Figure Interest Rate Pegging R M AB R* M min M max MsMs R max M0M0 M s max

Do Central Smooth Interest Rates?

Central Bank Independence and Inflation What does independence for a central bank mean? Usually refers to instrument independence but NO goal independence Germany and Switzerland are considered the most independent central banks What are some important influences on the degree of central bank autonomy? Politics and fiscal policy Is there a political business cycle? The importance of a compatible fiscal policy

Evaluating Central Bank Independence

Inflation rates in Selected Industrial Countries

The Inflation Control Record Inflation has fallen in all industrialized countries since the late 1980s, not just in inflation targeting countries The connection between central bank independence and inflation or economic growth is weak at best. Nevertheless, most observers think it is important to make central banks statutorily independent based in the overall inflation record

Statutory Characteristics of Central Bank Autonomy Monetary Policy Formulation Conflict Resolution Central Bank Objectives Term of Office Limitations on Lending to Government Accountability & Transparency

The Reaction Function Approach A quantitative measure of central bank performance The reaction function approach Changes in interest rates a function of key economic determinants (e.g., inflation, unemployment, exchange rates, foreign interest rates) Taylor’s rule: a popular way of measuring policy R t = * (- *) y gap + *

Taylor’s Rule for Canada

The Monetary Conditions Index In a small open economy interest rates and exchange rate movements are related The MCI is a linear combination of interest rate and exchange rate changes expressed in index form that recognizes this interdependence But the MCI is also problematical because interest rates and exchange rates can be affected by demand conditions as well as by portfolio reallocation

Summary Central banking is an “art” and involves the complex relationship between operating instruments through intermediate targets to final targets Central banks usually have to decide whether to smooth interest rates or target money supply growth Central bank independence and inflation performance, and possibly economic growth are believed to be related to each other and have been the focus of much policy discussions recently