PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 27 Interest Rate Targeting and Economic Activity

Copyright © 2004 South-Western. All rights reserved.27–2 Fundamental Issues 1.Why do most of the world’s central banks target nominal interest rates? 2.What are base drift and price-level nonstationarity, and what accounts for these phenomena? 3.How does interest rate targeting influence the term structure of interest rates? 4.Why are accurate inflation forecasts necessary for successful implementation of the Fed’s interest-rate-targeting procedure?

Copyright © 2004 South-Western. All rights reserved.27–3 Fundamental Issues (cont’d) 5.What are the international implications of interest rate targeting?

Copyright © 2004 South-Western. All rights reserved.27–4 Rationales for Interest Rate Targeting Its potential to be consistent with attaining economic stability. Interest rate targeting may be a more credible anti-inflation policy than alternative approaches to monetary policymaking.

Copyright © 2004 South-Western. All rights reserved.27–5 The Frequency of Central Bank Operations and Their Policy Targets Table 27–1 Frequency ofCentral Bank Policy OperationsOperating Target AustraliaDailyOvernight rate CanadaDailyOvernight rate European Monetary Union*DailyOvernight rate JapanAt least weeklyOvernight rate SwedenWeeklyOvernight rate United KingdomAt least weekly1- to 3-month rate United StatesDailyOvernight rate *Austria,Belgium,Finland,France,Germany,Greece,Ireland,Italy,Luxembourg, the Netherlands, Portugal, and Spain. SOURCE: Claudio E.V.Borio, “The Implementation of Monetary Policy in Industrial Countries: A Survey,” Bank for International Settlements Economics Papers, No. 47, July 1997.

Copyright © 2004 South-Western. All rights reserved.27–6 Problems with Interest Rate Targeting The problem of asymmetric information in monetary policymaking Credibility and signal-extraction problems:  A monetary policy signal provides information about the objectives of central bank officials.  A signal-extraction problem is the difficulty in trying to infer a policymaker’s true goals from the imperfect signal transmitted by the policymaker’s actions.

Copyright © 2004 South-Western. All rights reserved.27–7 Does Interest Rate Targeting Improve Central Bank Credibility? Interest rate targeting may improve the credibility of monetary policymaking for many central banks. Base drift:  The tendency of a measure of total depository institution reserves or a monetary aggregate to fail to adjust to a level consistent with fixed long-run average growth.

Copyright © 2004 South-Western. All rights reserved.27–8 Base Drift Figure 27–1a SOURCE: Alfred Broaddus and Marvin Goodfriend, “Base Drift and the Longer Run Growth of M1:Experience from a Decade of Monetary Targeting,” Federal Reserve Bank of Richmond Economic Review 70 (November/December 1984): 3–14.

Copyright © 2004 South-Western. All rights reserved.27–9 Base Drift (cont’d) Figure 27–1b SOURCE: Alfred Broaddus and Marvin Goodfriend, “Base Drift and the Longer Run Growth of M1:Experience from a Decade of Monetary Targeting,” Federal Reserve Bank of Richmond Economic Review 70 (November/December 1984): 3–14.

Copyright © 2004 South-Western. All rights reserved.27–10 Monetary Targeting Key Terms Monetary Targeting Key Terms Price-level nonstationarity:  Failure of the price level to adjust to a constant long-run average level; upward (or downward) drift of the price level over time. Interest rate smoothing:  Central bank efforts to attain an ultimate objective of interest rate stability.

Copyright © 2004 South-Western. All rights reserved.27–11 Alternative Rationales for Base Drift Monetary targeting Exchange rate smoothing International interdependence

Copyright © 2004 South-Western. All rights reserved.27–12 Interest Rate Smoothing, Base Drift, and Price-Level Nonstationarity Figure 27–2

Copyright © 2004 South-Western. All rights reserved.27–13 Monetary Policy and Interest Rates The federal funds rate as the “anchor” of the term structure.  Daily Fed targets Policy announcements and interest rate variability effects.  Monetary policy indicator:  An economic variable that gives the public an especially clear signal of the intended effects of monetary policy actions.

Copyright © 2004 South-Western. All rights reserved.27–14 Interest Rate Targeting and the Economy The Fed’s Balancing Act:  The Liquidity Effect versus the Real-Balance Effect. Interest Rate Targeting and Expected Inflation:  In the long run the Fed’s interest rate target should be consistent with the current expected inflation rate, which in turn should ultimately be consistent with the path of actual inflation.

Copyright © 2004 South-Western. All rights reserved.27–15 Implications of Interest Rate Targeting for the World Economy Effects of nearby and large nations’ monetary policies make it difficult for smaller countries to maintain control of:  Interest rate targeting  International interest parity  Exchange rates

Copyright © 2004 South-Western. All rights reserved.27–16 Key Terms Currency board:  An institution that issues currency at a fixed rate of exchange with respect to another nation’s currency. Dollarization:  A country’s adoption of the U.S. dollar as its sole medium of exchange, unit of account, store of value, and standard of deferred payment.

Copyright © 2004 South-Western. All rights reserved.27–17 Interest Rate Targets of Major Central Banks since 1993 Figure 27–3 SOURCES: Christopher Neely, “International Interest Rate Linkages,” Federal Reserve Bank of St.Louis International Economic Trends, August 2001; Bank of Canada, Bank of England, European Central Bank, and Board of Governors of the Federal Reserve System.