Chapter 24 Strategies and Rules for Monetary Policy Introduction to Economics (Combined Version) 5th Edition

The Search for a Strategy  The goals of macroeconomic policy are stability and prosperity.  What kind of strategy is best?  Would it be a strategy of fine tuning that makes frequent changes to policy and reacts to every small event?  Or a strategy of policy rules that sets policies in advance for greater transparency and predictability? Introduction to Economics (Combined Version) 5th Edition

Fine-Tuning in the U.S. Economy  U.S. policymakers attempted to fine-tune the economy in the 1960s and 1970s.  Because of lags, forecasting errors, and time-inconsistency, the result was a series of business cycles with increasing inflation and unemployment. Introduction to Economics (Combined Version) 5th Edition

Lags  Inside lags are delays between the time a problem develops and the time a decision is taken to do something about it.  Examples:  Delays in data collection  Time needed to conduct meetings, prepare reports, and reach decisions  Outside lags are delays between the time a decision is made and the time actions affect the economy.  Examples:  Delays in implementing a decision  Delays in movements along and shifts in aggregate supply and demand curves Introduction to Economics (Combined Version) 5th Edition

Inside Lag: Example  The U.S. had a mild recession in Jan-Nov  May 2001 vintage data (the data available in the middle of the recession) did not show start of recession, even when it was half over.  Fully revised data shows the start of the recession clearly. Introduction to Economics (Combined Version) 5th Edition

Outside Lag: Example  After an increase in interest rates shifts the AD curve, real output first falls and then returns to the natural level after the AS curve shifts.  These estimates show that the process involves a total lag of 1 to 3 years, or longer.  Different studies, based on different periods and methods, do not agree on how long the lag is. Introduction to Economics (Combined Version) 5th Edition

Forecasting Errors  To overcome the problem of lags, policymakers must try to act in advance, based on forecasts.  However, forecasts are not accurate. On average, forecasts of GDP growth have an error of about  1 percent for 1 year forecasts in developed countries  2 percent for 2 year forecasts in developed countries  3 percent for 2 year forecasts in developing countries  Forecasts are least accurate at turning points in the business cycle, just when they are needed most. Introduction to Economics (Combined Version) 5th Edition

Time-Inconsistency  Time-inconsistency means the tendency to make decisions that have good consequences in the short run, but bad consequences in the long run.  Example from everyday life: You stop taking your medication because of bad side effects before you are completely cured.  Example from macroeconomics: Before an election, policymakers use excessive expansionary policy or avoid needed contractionary monetary policy. Introduction to Economics (Combined Version) 5th Edition

Instruments, Targets, and Goals  A policy instrument is a variable that is directly under the control of policymakers.  An operating target is a variable that responds immediately, or almost immediately, to the use of a policy instrument.  An intermediate target is a variable that responds to the use of a policy instrument or a change in operating target with a significant lag.  A policy goal is a long-run objective of economic policy that is important for economic welfare. Introduction to Economics (Combined Version) 5th Edition

Monetarism  Monetarists like Milton Friedman advocated the use of a steady rate of money growth, approximately equal to the long-run rate of growth of real output, as an intermediate target.  If velocity was reasonably stable, a money growth rule would avoid excessive inflation or deflation. Equation of Exchange MV = PQ where – M is the money stock – V is velocity – P is the price level – Q is the rate of GDP growth If V is constant and growth of M equals growth of Q, P will be constant. Introduction to Economics (Combined Version) 5th Edition

Inflation Targeting  The rate of inflation averaged over one or two years is the main intermediate target.  Interest rates are used as the operating target.  Open market operations are used as the main policy instrument. Introduction to Economics (Combined Version) 5th Edition

Interest Rates as an Operating Target  The Fed sets the discount rate on loans to banks and the deposit rate charged on reserves to form a corridor.  The federal funds target rate is set in the middle of the corridor.  Open market operations are used to adjust the supply of reserves to keep the federal funds rate close to its target. Introduction to Economics (Combined Version) 5th Edition

Adjusting the Interest Rate Target  Inflation targeting policy sets an upper and lower limit for growth of the price level to form a cone around the intended inflation target.  If the actual inflation rate threatens to move outside the cone, the interest rate target is raised to slow growth of aggregate demand. Introduction to Economics (Combined Version) 5th Edition

A Taylor Rule  A Taylor Rule uses both the inflation rate and the output gap as intermediate targets.  The interest rate operating target is raised if either the inflation rate or output gap increases.  The interest rate is lowered if inflation or the output gap decreases.  To avoid lags in measuring the output gap, a variation of the Taylor rule uses employment data. Introduction to Economics (Combined Version) 5th Edition Stanford University economist John Taylor

NGDP Targeting  NGDP targeting is a policy under which the central bank adopts the rate of growth of nominal GDP as its principal intermediate target.  NGDP targeting is more flexible than simple monetary targeting.  Under NGDP targeting, an unexpected increase in velocity could be offset by a slowdown in the rate of growth of the money stock, or vice versa. Introduction to Economics (Combined Version) 5th Edition During the Great Recession, NGDP dropped far below its potential level.

Appendix to Chapter 24 Demand and Supply for Money Introduction to Economics (Combined Version) 5th Edition

The Demand for Money  The demand for real money balances means the real quantity of money people want to hold, other things being equal.  A decrease in the interest rate decreases the opportunity cost of holding money and causes a movement along the demand curve (A to B).  An increase in real income causes the money demand curve to shift to the right (A to C). Introduction to Economics (Combined Version) 5th Edition

A Change in the Interest Rate  The supply of money is controlled by the central bank using open market operations or other instruments.  The following could cause an increase in the interest rate:  An increase in real GDP, shifting the demand curve  A decrease in the real money supply while the price level and real GDP are constant  An increase in the price level while real GDP and the nominal money supply are constant Introduction to Economics (Combined Version) 5th Edition