1. Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 3
Chapter Eighteen
Chapter 18
Monetary Policy: Stabilizing the Domestic Economy
Part 3

2. Linking Tools to Objectives
OMO
Discount Rate
Reserve Req.
Deposit rate

3. Linking Tools to Objectives
Monetary goals are given to policy makers by their elected officials.
Fed, dual mandate
ECB, price stability
BoE, inflation target
But day-to-day policy is left to the technicians.

4. Linking Tools to Objectives: Making Choices
The reserve requirement is not useful as a policy tool – too powerful,
Central bank lending (discount loans) as a tool is necessary to ensure financial stability, and
OMO - Short-term interest rates are the instrument of choice used to stabilize short-term fluctuations in prices and output.

5. Desirable Features of a Policy Instrument
Easily observable by everyone
Ensure transparency in policymaking, which enhances accountability.
It is controllable and quickly changed
It is tightly linked to goals and objectives
- the more predictable the impact of an instrument, the easier it will be for policymakers to meet their objectives.

6. Which Instrument?
Interest rate or monetary aggregate?
choice between controlling quantity variable (monetary base) or controlling price variable (federal funds rate)?

7. Which Instrument?
Central banks in the world today choose to target an interest rate (price) rather than reserves (quantity).
Targeting reserves creates interest rate volatility.

8. Result of Targeting Reserves
Federal
Funds Rate
Rd′′
Rd′ Rs
NBR*
A rightward or leftward shift in the demand curve for
reserves …
leads to fluctuations in the
federal funds rate
Rd*
Quantity of
Reserves, R
With reserve supply fixed, shifts in reserve demand changes the federal funds rate.

9. Result of Targeting the Federal Funds Rateid
ier
Federal Funds Rate
Step 1. A rightward or leftward shift in the demand curve for reserves…
Step 2. leads the central bank to shift the supply curve of reserves so that the federal rate does not change…
Federal Funds Rates Target,
Step 3. with the result that non-borrowed reserves fluctuate between NBR′ff and NBR′′ff.
Quantity of Reserves, R

10. Side Note -
Under Paul Volker, from 1979 to 1982, the Fed “targeted reserves” rather than interest rates.
We saw interest rates that would not have been politically acceptable if the Fed announced interest rates as targets.
Since they said they were targeting reserves, the Fed escaped responsibility for the high interest rates.
When inflation had fallen and interest rates came back down, the FOMC reverted to targeting the federal funds rate.

11. “Intermediate Targets”
Central bankers sometimes use the terms operating instrument and intermediate target.
The FFR is the Fed’s ‘operating instrument”, we’ll just use instrument
The term intermediate targets refers to instruments that are not directly under the policy maker’s control, but lie somewhere between their policy tools and their objectives.

12. Intermediate Targets
A monetary aggregate such as the money supply is a prime example of intermediate target.
The idea being that changes in the monetary base affect the monetary aggregates which in turn affect output and inflation.
M1 = m x MB
intermediate target
Instrument

13. Link 1 is weak and Link 2 is weak. Focus on Link No. 3.
Central bankers have largely abandoned the idea of intermediate targets and focus directly on policy objectives
TOOLS
OMO
Discount Rate
Reserve Req.
Deposit rate
Link 1 is weak and Link 2 is weak.
Focus on Link No. 3.

14. Inflation Targeting
One approach for linking instrument to goal is inflation targeting .
Bypasses intermediate targets and focuses on the final objective of low stable prices.
How it works:
Public announcement of numerical target,
Commitment to price stability as primary objective, and
Frequent public communication.
Benefit - Inflation targeting increases policymakers’ accountability and helps to establish their credibility.

15. A Guide to Central Bank Interest Rates: The Taylor Rule
How does or should the FOMC sets the target federal funds rate?
The Taylor Rule:
Relates the target federal funds rate to the real interest rate, inflation, and output.
Target Fed Funds rate = 2% + Current Inflation
+ ½ (Inflation gap)
+ ½ (Output gap)
These are all percentages.
Published in 1993 based on data covering 1987 – 1992.

16. A Guide to Central Bank Interest Rates: The Taylor Rule
This equation as presented assumes the long-term real interest rate consistent with full employment is 2 percent.
Called the “neutral” real rate = r*
The inflation gap is current inflation minus an inflation target.
The output gap is
(current GDP - potential GDP)/ potential GDP
The percentage deviation of current output from potential output.

17. The Taylor Rule: How it Works
Suppose target inflation is 2% and actual inflation is on target at 2%, and there is no output gap….
The target nominal federal funds rate should be set at its “neutral” target real rate (r*) of 2% plus 2% inflation.
FFR = 2% + 2% + 0.5(0) + 0.5(0)
FFR = 4% .
This is the nominal FFR consistent with full employment and stable inflation at target.

18. The Taylor Rule: How it Works
When inflation rises above its target level,
Response is to raise interest rates.
When output falls below the target level,
Response is to lower interest rates.

19. Taylor Rule - Examples
Economy at full employment, but inflation above target at 3%:
Target iff = ( 3.0 – 2.0) (0) = 5.5 percent
Inflation on target, but economy 3% less than full employment:
Target iff = ( 2.0 – 2.0) (-3.0) = 2.5 percent
Inflation below target (1%) and economy 3% below full employment:
Target iff = ( 1.0 – 2.0) (-3.0) = 1.0 percent

20. Question: If inflation rises 1% above target, why is the FFR increased by 1.5%?
iff = ( 2.0 – 2.0) (0) = 4.0 percent
iff = ( 3.0 – 2.0) (0) = 5.5 percent

21. The Taylor Rule: How it Works
A 1 percentage point increase in the inflation rate raises the target federal funds rate 1½ percentage points.
Which means the FFR in real terms increases which is needed to slow the economy.
The Taylor rule also states that for each percentage point output is above potential:
Target FFR should increase by half a percentage point.

22. The Taylor Rule: How it Works
The weights are not fixed and do not have to sum to one.
The weights in the equation depend on preferences of central bankers.
The more bankers care about inflation:
The bigger the weight for the inflation gap, and the lower the weight for the output gap.

23. Implementation of the The Taylor Rule
The Taylor rule requires four inputs:
The constant term, r*. Set 2 in the original Taylor formulation.
this is the real interest rate consistent with full employment.
a lot of economist think this is currently much lower that 2% - go back and read the Blinder article.
A measure of inflation;
A measure of the inflation gap; and
A measure of the output gap.

24. Implementation of the Taylor Rule
The Fed uses the personal consumption expenditure (PCE) index to measure of inflation.
The PCE comes from the national income accounts.
The output gap is the percentage by which GDP deviates from a measure of its trend or potential GDP.

25. A Guide to Central Bank Interest Rates: The Taylor Rule
Figure in the book plots the FOMC’s actual target federal funds rate, together with the rate predicted by the Taylor rule.
The two lines are reasonably close to each other indicating the FOMC usually changed the target federal funds rate when the Taylor rule predicted it should.

26. A Guide to Central Bank Interest Rates: The Taylor Rule

27. 2011-2012 Rule 1: iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*)
Y* = Potential GDP
Using Data for 2011/12: π= 2%, gap = -6%:
Rule 1: iff = (2) + .5(-6) ; iff = 1 percent
What if the output gap coefficient is 1.0.
Rule 2: iff = (2) + 1.0(-6); iff = -2 percent

28. Re-arrange terms iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*)
Y* = Potential GDP
Using Data for 2011/12: π= 2%, gap = -6%:
Rule 1: iff = (2) + .5(-6) ; iff = 1 percent
What if the output gap coefficient is 1.0.
Rule 2: iff = (2) + 1.0(-6); iff = -2 percent

29. Comparison of Rule 1 and Rule 2
March 2013

30. Did Greenspan follow the Taylor Rule?
“ … rules that relate the setting of the federal funds rate to the deviations of output and inflation from their respective targets, in some configurations, do seem to capture the broad contours of what we did over the past decade and a half.”[1]
[1] Greenspan, Alan, “Risk and Uncertainty in Monetary Policy,” American Economic Review, May 2004, pp The quoted passage appears on pages

31. Policy Strategies: Inflation Targeting
New Zealand, Canada and the UK have explicit inflation targets - around 27 countries in total.
Bank of Canada Governor Gerry Bouey, who reputedly remarked that "we didn't abandon monetary aggregates, they abandoned us".
With inflation targeting, the central bank bypasses intermediate targets and focuses on the final objective. Link #3 in the next slide.

32. Policy Strategies: Inflation Targeting
Link #1
Link #2
Link #3
The Policy Instrument is linked to a single goal. 32

33. Inflation Targeting New Zealand (1990) Canada (1991)
Part of central bank reform in 1990
Sole objective is price stability with an explicit target–range.
Inflation was brought down and remained within the target range most of the time.
Governor of the central bank is accountable and can be dismissed.
Canada (1991)
Explicit target range.
Inflation brought down, some costs in term of unemployment
United Kingdom (1992)
Part of central bank reform in 1992
Explicit Target

34. Central Bank Web Pages http://www.rbnz.govt.nz/
Click on Monetary Policy
Click on Monetary Policy Framework

35. Inflation Targeting – How does it work?
Stated commitment to price stability as the primary long-run goal of monetary
Increase transparency of the strategy with public announcement of a numerical inflation target
Can not renege.
Increased accountability of the central bank 35

36. Inflation Targeting - Intent
Keep inflation low and anchor inflation expectations (πe) - “nominal anchor”
This, in turn, will anchor long-term interest rates to promote growth.
i = r + πe
Follows a hierarchical mandate: inflation first, everything else second or explicit mandate.
Remember: Fed has a dual mandate. Has shied away from adopting inflation targeting.

37. Inflation Targeting - Advantages
Stable relationship between money supply and inflation (link #2)is not needed.
Easily understood.
Focus is long term inflation goal.
Stresses transparency and accountability
Reduce time-inconsistency problem

38. The time inconsistency of discretionary policy
Definition - A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement.
Destroys policymakers’ credibility
reducing effectiveness of policies.
Understanding that policymakers may be inconsistent over time, private decision makers are led to distrust policy announcements.

39. Examples of time inconsistency
To encourage investment, gov’t announces it will not tax income from capital investment.
But once the factories are built, gov’t reneges in order to raise more tax revenue.

40. Examples of time inconsistency
To reduce expected inflation, the central bank announces it will tighten monetary policy.
But, faced with high unemployment, the central bank may be tempted to cut interest rates.

41. Examples of time inconsistency
Aid is given to poor countries contingent on fiscal reforms.
The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries’ citizens to starve.

42. Inflation Targeting - Disadvantages
“Delayed signaling”
Effects of change in policy on inflation only revealed after long lags (12 to 24 months)
Some economist argue too much rigidity
However, in practice there is policy discretion, target is within a range, say 1% to 3%
Better described as “flexible inflation targeting.”
Potential for increased output fluctuations.
For example, with sole focus on inflation, monetary policy may be too tight if π > target, leading to greater fluctuations in output.

43. Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–200843

44. US. Inflation - Without Explicit Inflation Target

45. US - Monetary Policy with an Implicit Nominal Anchor
The previous chart shows the US has achieved good results without an explicit nominal anchor.
Fed strategy has been to follow and implicit nominal anchor.
Fed policy must be forward looking and preemptive
The goal is to prevent inflation from getting started.
Lag between implementation and impact on real output is about 1 year and about 2 years to affect inflation

46. US Monetary Policy with an Implicit Nominal Anchor
Advantages
Uses many sources of information
Demonstrated success
Disadvantages
Lack of transparency and accountability
Strong dependence on the preferences, skills, and trustworthiness of individuals in charge
Inconsistent with democratic principles <= Pooh! 46

47. Important Summary Table Advantages and Disadvantages of Different Monetary Policy Strategies47

48. Price-Level Targeting
Price-level Targeting The central bank targets the rate of increase of the price level.
Many economists consider a 2% annual increase in the price level to be appropriate in the long run.
(CPI or PCE)
A key question is where to start. 2007?, 2008, 2014?

49. Inflation Targeting
Inflation targeting also aims to move the economy along a pre-set path
If fully successful, the economy would follow exactly the same path as under price-level targeting
(CPI or PCE)
Inflation target path

50. Inflation and Price-Level Targeting Compared
The two policies differ when the economy strays from its intended path, for example, at point A.
Under inflation targeting, the aim is to put the economy on a new path parallel to, but below the original one (dashed red line). “Trend drift”
Price-level targeting aims to return to the original path (dashed green line)
2% inflation

51. The Claimed Advantage of Price-Level Targeting
Along the segment A-B, PLT would require a more expansionary policy to produce a rate of inflation higher than 2%.
Low inflation at A is likely to be accompanied by high unemployment, price-level targeting would bring unemployment back to normal faster than inflation targeting. Faster rate of growth in the money supply.
> 2% inflation

52. PLT when Inflation is High

53. Posting P100130 from Ed Dolan’s Econ Blog http://dolanecon. blogspot

54. Criticisms of Price-Level Targeting
Critics of PLT fear that rapid inflation along the segment A-B would destabilize inflation expectations (become “unanchored”) and raise risk premiums in financial markets
Also worry that PLT would undermine the central bank’s credibility.
The fear is that if the central bank promotes high inflation, if only for a brief period, people would come to doubt its inflation-fighting intentions in the future

55. PLT with Negative Supply Shock
Critics say that PLT would work poorly when an external supply shock (say, a world oil price rise) causes inflation to drift above its 2% target path.
PLT would then require a strong contractionary policy in order to decrease the price level until the average price level returned to its original path
In this case, it might be better to let bygones be bygones, and start a new target path at A

56. Concerns about Negative Supply Shock
Supporters of Price Level Targeting tend to agree that PLT would not work well against high inflation caused by an external supply shock
The Fed should be clear about the kinds of circumstances in which PLT would be used, and those in which it would not be used

57. ZLB and Inflation Targeting
Consider a situation where the economy has been hit by a large negative shock to aggregate demand – a recession.
Nominal interest rates have been cut to zero (ZLB) in an attempt to stimulate the economy back to full capacity.
With inflation targeting and expectations anchored at 2%, the only route monetary policy could stimulate the economy is further cuts in nominal interest rates
An option which has been exhausted at this point.
ZLB

58. ZLB and Inflation Targeting
If households and firms understand the impotence of monetary policy, they might even expect lower future inflation.
This would raise real interest rates, thus pushing down demand even further, extending the recession

59. ZLB and Price Level Targeting
Targeting the price level leads to a different dynamic for inflation expectations.
A credible price-level target would create the expectation of future inflation of more than 2%.
This expectation will lower real interest rates today and provide necessary stimulus to aggregate demand and upward pressure on prices.