© 2008 Pearson Education Canada18.1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics

© 2008 Pearson Education Canada18.2 The Price Stability Goal Low and stable inflation Inflation –Creates uncertainty and difficulty in planning for future –Lowers economic growth –Strains social fabric Nominal anchor ignore Time-inconsistency problem ignore

© 2008 Pearson Education Canada18.3 Other Goals of Monetary Policy High employment Economic growth Stability of financial markets Interest-rate stability Foreign exchange market stability

© 2008 Pearson Education Canada18.4 Should Price Stability be the Primary Goal? In the long run there is no conflict between the goals In the short run it can conflict with the goals of high employment and interest-rate stability Hierarchical mandate Dual mandate

© 2008 Pearson Education Canada18.5 Monetary Targeting Flexible, transparent, accountable Advantages –Almost immediate signals help fix inflation expectations and produce less inflation –Almost immediate accountability Disadvantages –Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate

© 2008 Pearson Education Canada18.6 Inflation Targeting Public announcement of medium-term numerical target for inflation Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal Information-inclusive approach in which many variables are used in making decisions Increased transparency of the strategy Increased accountability of the central bank

© 2008 Pearson Education Canada18.7 Inflation Targeting In Canada In 1991, the minister of finance and the governor of the Bank of Canada established formal inflation targets The target range was 2-4% by the end of 1992, 1.5-3% by June 1994 and 1-3% by December 1996

© 2008 Pearson Education Canada18.8 After a new government took office in 1993, the target was set at 1-3% and has been kept at this level ever since Canadian inflation has fallen dramatically since the adoption of targets, falling from 5% in 1991, to zero in 1995 and between 1-2% in the late 1990’s

© 2008 Pearson Education Canada18.9 Inflation Targeting

© 2008 Pearson Education Canada18.10 Inflation Targeting (Cont’d) Advantages –Does not rely on one variable to achieve target –Easily understood –Reduces potential of falling in time-inconsistency trap –Stresses transparency and accountability

© 2008 Pearson Education Canada18.11 Disadvantages –Delayed signaling –Too much rigidity –Potential for increased output fluctuations –Low economic growth

© 2008 Pearson Education Canada18.12 Implicit Nominal Anchor Brief discussion Forward looking and preemptive Advantages –Uses many sources of information –Avoids time-inconsistency problem –Demonstrated success

© 2008 Pearson Education Canada18.13 Disadvantages –Lack of transparency and accountability –Strong dependence on the preferences, skills, and trustworthiness of individuals in charge –Inconsistent with democratic principles

© 2008 Pearson Education Canada18.14 Advantage and Disadvantages of Different Monetary Strategies

© 2008 Pearson Education Canada18.15 Tactics: Choosing the Policy Instrument Tools –Open market operation –Government deposit shifting –Last resort lending –Overnight interest rate

© 2008 Pearson Education Canada18.16 Policy instrument (operating instrument) –Reserve aggregates –Interest rates –May be linked to an intermediate target Interest-rate and aggregate targets are incompatible

© 2008 Pearson Education Canada18.17 Result of Targeting Non- borrowed Reserves Brief

© 2008 Pearson Education Canada18.18 Result of Targeting Non- borrowed Reserves

© 2008 Pearson Education Canada18.19 Result of Targeting Overnight Funds

© 2008 Pearson Education Canada18.20 The Taylor Rule, NAIRU, and the Phillips Curve (brief) Overnight interest rate = inflation rate + equilibrium overnight rate + ½ (inflation gap) + ½ (output gap) An inflation gap and an output gap –Stabilizing real output is an important concern –Output gap is an indicator of future inflation as shown by Phillips curve

© 2008 Pearson Education Canada18.21 NAIRU –Rate of unemployment at which there is no tendency for inflation to change