Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 14 The Goals, Tools, and Rules of Monetary Policy

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Introduction to Stabilization Policies Stabilization policies aim at minimizing changes to real GDP from exogenous Demand Shocks including: –Changes in business and consumer optimism –Changes in net exports –Changes in government spending and/or taxes not related to stabilization policy Policy Activism purposefully changes the settings of the instruments of monetary and fiscal policy to offset changes in private sector spending. –An alternate approach recommends Policy Rules that call for a fixed path of a policy instrument like the money supply or a target variable like inflation or unemployment.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Policy Rules and Monetary Policy In the 1930s, University of Chicago economist Henry Simons posed a stark contrast between a totally discretionary monetary policy and a fixed rule. –A Discretionary Policy treats each macroeconomic episode as a unique event without a common approach to all events. –A Rigid Rule for policy sets a key policy instrument at a fixed value. In the 1950s, Milton Friedman advocated a Constant Growth Rate Rule (CGRR) that stipulated a fixed percentage growth rate for the money supply. He was part of the Monetarism school of thought. A Feedback Rule sets stabilization policy to respond in a systematic way to a macroeconomic event (e.g. the “Taylor” Rule)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-1 A Flowchart Showing the Relationship Between Policy Instruments, Policy Targets, and Economic Welfare

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Rules vs. Activism Debate One way to distinguish between policy activists vs. rules activists is their degree of optimism of the self-correcting mechanism of the economy vs. the efficacy of stabilization policies:

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Positive Case for Rules Milton Freidman’s arguments for monetary policy rules: –A rule insulates the Fed from political pressure –A rule allows the Fed’s performance to be judged –A rule reduces uncertainty Weakness of these arguments: –With no political pressure, Fed may accept too high U in order to fight inflation –The public may not care about the target variables chosen by the Fed, and so may not care about the performance and/or certainty of that variable

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Negative Case for Rules Rules are favorable to discretionary policies because of the “long and variable” lags between changes in monetary policy instruments and the ultimate response of target variables like inflation and unemployment. Five types of lags and their estimated duration:

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-2 The Percent Change in Real GDP Following a 1 Percentage Point Change in the Federal Funds Rate, Three Intervals, 1961–2010

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Multiplier Uncertainty The multiplier formulas from Chapters 3 and 4 showed the size of the change in real GDP that would result from a change in a policy instrument. Dynamic Multipliers are the amount by which output is raised during each of several time periods after a given change in the policy instrument. Multiplier Uncertainty concerns the lack of firm knowledge regarding the change in output caused by a change in a policy instrument.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Longer Lags and Smaller Multipliers Since the 1960s, lags have become longer and multipliers have become smaller. Why? –Housing sector has changed Financial deregulation has lessened the impact a rise in interest rates have on housing, thereby blunting the force of monetary policy –More consumption financed by credit cards Credit card rates are not sensitive to changes in monetary policy, thus dampening the effects of monetary policy on consumption –The adoption of flexible exchange rates in 1973 Now monetary policy also affected exchange rates, and therefore, after a long two-year lag, net exports

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Fed and “The Great Moderation” Why has there been a decline in economic volatility since the mid-1980s? –In other words, what caused “The Great Moderation?” Possibility 1: Smaller Demand and Supply Shocks –Government military spending fell and was more stable –Financial deregulation made residential construction less volatile –Computers and improved management practices reduced the volatility of inventory investment. –The oil and farm prices shocks of the 1970s were absent in the 1980s. Possibility 2: Improved Federal Reserve Performance –The Fed moved rapidly and decisively in response to movements in the log output ratio.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-3 The Output Gap and the Moving Average of its Absolute Value, 1960–2010 (1 of 2)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-3 The Output Gap and the Moving Average of its Absolute Value, 1960–2010 (2 of 2)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-4 The Federal Funds Interest Rate and the Log Output Ratio, 1980–2007

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Time Inconsistency and Policy Credibility Time Inconsistency describes the temptations of policymakers to deviate from a policy after it is announced and private decision-makers have reacted to it. Policy Credibility is the belief by the public that policymakers will actually carry out an announced policy.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Taylor Rule Stanford University economist John Taylor has proposed a simple rule (called the Taylor Rule) for the Fed to follow in setting the real federal funds rate (r FF ): r FF = r FF* + a(p – p*) + b[ln(Y/Y N )] (where * represents the desired or target levels of variables and a, b are parameters > 0) –If the Fed cares about avoiding accelerating inflation, then “a” is large. –If the Fed cares about avoiding recession and/or high unemployment, then it chooses a large “b.”

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 14-5 The Actual Federal Funds Rate and Interest Rates Calculated by the Taylor Rule, 1980–2010

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Nominal GDP Rule A nominal anchor is a rule that sets a limit on the growth rate of a nominal variable (like H, M S, P or PY) –Goal is to prevent runaway inflation Recall: Growth rate for nominal GDP = p + y A nominal GDP rule limits p + y –Main benefit is in response to supply shocks  No response necessary as p ↑ offset by y ↓ –Same as a Taylor rule that places equal weights on inflation and real GDP growth Note: Taylor rule expressed in terms of inflation and level of real GDP In response to deep recessions, Taylor rule is more stimulative than nominal GDP rule since output gap may be large even as y > 0 –Subject to forecasting errors and long implementation lags

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Table 14-1 Assessing Alternative Policy Rules (1 of 2)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Table 14-1 Assessing Alternative Policy Rules (2 of 2)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The Debate About The Euro What are the benefits and costs of a single currency for the EU? Benefits –Elimination of costs and risks associated with exchange rates  improved intra-EU commerce –Monetary and fiscal discipline  lower inflation Costs –No independent control over M S –Prohibition of fiscal deficits over 3% limits automatic stabilization during recessions

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Perspective The Debate About the Euro

Copyright © 2012 Pearson Addison-Wesley. All rights reserved M S and Targeting Exchange Rates Under flexible exchange rates, an expansionary monetary policy lowers interest rates, leading to a depreciation that boosts NX and therefore output Under fixed exchange rates, monetary policy must be used to maintain the fixed exchange rate, and therefore is no longer available for stabilization purposes –This signals the central bank intention to keep inflation low