1. CHAPTER 25 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Monetary Policy: A Summing Up Prepared by: Fernando Quijano and Yvonn Quijano

2. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 35 The Optimal Inflation Rate Inflation has steadily gone down in rich countries since the early 1980s. The attempt to reduce it even further depends on the costs and benefits of inflation. Table 25-1 Inflation Rates in the OECD, 1981-2000 19811985199019952003 OECD average*10.5%6.6%6.2%5.2%2.0% Number of countries with inflation below 5%**210152127 * Average of GDP deflator inflation rates, using GDPs at PPP prices as weights. **Out of 30 countries. 25-1 Monetary Policy: What You Have Learned and Where A quick review of Chapters 4 through 24 and an overview of the information presented in Chapter 25

3. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 35 The Costs of Inflation We’ve seen how very high inflation can disrupt economic activity. The debate in OECD countries today, however, centers on the advantages of, say, 0% versus 4% inflation a year. Within that range, economist identify four main costs of inflation: (1) shoe-leather costs, (2) tax distortions, (3) money illusion, and (4) inflation variability.

4. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 35 Shoe-Leather Costs Shoe-leather costs are the costs of making more trips to the bank in the presence of inflation. They reflect an increase in the opportunity cost of holding money.

5. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 35 Tax Distortions Tax distortions occur when tax rates do not increase automatically with inflation, a concept known as bracket creep. Income for purposes of taxation includes nominal interest payments, not real interest payments.

6. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 35 Money Illusion Money illusion is the cost of inflation associated with the notion that people make systematic mistakes in assessing nominal versus real changes, leading people to make incorrect decisions.

7. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 35 Inflation Variability Inflation variability means that financial assets such as bonds, which promise fixed nominal payments in the future, become riskier. Money Illusion After conducting a survey, it’s suggested that money illusion is very prevalent and that people have a hard time adjusting for inflation.

8. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 35 The Benefits of Inflation Inflation is actually not all bad. One can identify three benefits of inflation: (1) seignorage, (2) the option of negative real interest rates for macroeconomic policy, and (3) the use of the interaction between money illusion and inflation in facilitating real wage adjustments.

9. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 35 Seignorage Seignorage, or the revenues from money creation, allow the government to borrow less from the public, or to lower taxes. An economy with a higher average inflation rate has more scope to use monetary policy to fight a recession. The presence of inflation allows for downward real-wage adjustments more easily than when there is no inflation.

10. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 35 The Option of Negative Real Interest Rates In short, an economy with a higher average inflation rate has more scope to use monetary policy to fight a recession. An economy with a low average inflation rate may find itself unable to use monetary policy to return output to a natural level of output.

11. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 35 Money Illusion Revisited Paradoxically, the presence of money illusion provides at least one argument for having a positive inflation rate. The presence of inflation allows for downward real-wage adjustments more easily than when there is no inflation.

12. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 35 The Optimal Inflation Rate: The Current Debate Those who aim for small but positive inflation argue that some of the costs of positive inflation can be avoided, and the benefits are worth keeping. Those who aim for zero inflation argue that this amounts to price stability, which simplifies decisions and eliminates money illusion. Today, most central banks appear to be aiming for a low but positive inflation, between 2 and 3%.

13. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 35 The Design of Monetary Policy Most central banks have adopted an inflation rate target rather than a nominal money growth rate target. And, they think about short-run monetary policy in terms of movements in the nominal interest rate rather than in terms of movements in the rate of nominal money growth. 25-2

14. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 35 Money Growth Targets and Target Ranges Until the 1990s, monetary policy, in the US and other OECD countries, was typically conducted as follows:  The central bank chose a target rate for nominal money growth corresponding to the inflation rate it wanted to achieve in the medium run.  In the short run, the central bank allowed for deviations of nominal money growth from the target.  To communicate to the public both what it wanted to achieve in the medium run and what it intended to do in the short run, the central bank announced a range for the rate of nominal money growth.

15. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 35 Money Growth and Inflation Revisited M1 Growth and Inflation: 10-year averages, 1970-2003 There is no tight relation between M1 growth and inflation, not even in the medium run. Figure 25 - 1

16. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 35 Money Growth and Inflation Revisited The relation between M1 growth and inflation is not tighter because of shifts in the demand for money. When people reduce their bank account balances and move to money market funds, there is a negative shift in the demand for money. Frequent and large shifts in money demand created serious problems for central banks.

17. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 35 Inflation Targeting In many countries, central banks have defined as their primary goal the achievement of a low inflation rate, both in the short run and in the medium run. This is known as inflation targeting.  Trying to achieve a given inflation target in the medium run would seem a clear improvement over trying to achieve a nominal money growth target.  Trying to achieve a given inflation target in the short run would appear to be much more controversial.

18. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 35 Measures that include not only money but other liquid assets are called monetary aggregates, under the name of M2, M3, and so on. In the United States, M2 is also called broad money. The central bank could choose M2 growth as target, however the relation between M2 growth and inflation is not very tight either, and the central bank does not control M2. Many financial assets are very liquid, which makes them attractive as substitutes for money. However, these assets are not included in M1. The Unsuccessful Search for the Right Monetary Aggregate

19. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 35 Figure 1 The Unsuccessful Search for the Right Monetary Aggregate M2 Growth and Inflation: 10-year averages, 1970-2003

20. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 35 Inflation Targeting The result that we have just derived – that inflation targeting eliminates deviations of output from its natural level – is too strong, however, for two reasons:  The central bank cannot always achieve the rate of inflation it wants in the short run.  Like all other macroeconomic relations, the Phillips curve relation does not hold exactly.

21. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 35 Interest Rate Rules According to the Taylor rule, since it is the interest rate that directly affects spending, the central bank should choose an interest rate rather than a rate of nominal money growth. Taylor’s rule provides a way of thinking about monetary policy: once the central bank has chosen a target rate of inflation, it should try to achieve it by adjusting the nominal interest rate.

22. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 35 Interest Rate Rules,  If, and, then the central bank should set i t equal to its target value, i*.  If inflation is higher than the target, the central bank should increase the nominal interest rate i t above i*.  If unemployment is higher than the natural rate of unemployment (u>u n ), the central bank should decrease the nominal interest rate.

23. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 35 Interest Rate Rules Since it was first introduced, the Taylor rule has generated a lot of interest, both from researchers and from central banks:  Researchers looking at the behavior of both the Fed in the US and the Bundesbank in Germany have found the rule describes their behavior over the last 15-20 years.  Other researchers have explored whether it is possible to improve on this simple rule.

24. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 35 Interest Rate Rules Since it was first introduced, the Taylor rule has generated a lot of interest, both from researchers and from central banks:  Yet other researchers have discussed whether central banks should adopt an explicit interest rate rule and follow it closely.  In general, most central banks have now shifted to thinking in terms of an interest rate rule.

25. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 35 The Fed in Action The mandate of the Federal Reserve System was most recently defined in the Humphrey- Hawkins Act, passed by Congress in 1978. For more information on how the Fed is organized, go to the Fed’s Web site: www.federalreserve.gov/ www.federalreserve.gov/ 25-3

26. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 35 The Organization of the Fed The Federal Reserve System is composed of three parts:  A set of 12 Federal Reserve Districts  The Board of Governors  The Federal Open Market Committee (FOMC) and the Open Market Desk.

27. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 35 The Instruments of Monetary Policy The equilibrium interest rate is the interest rate at which the supply (left side) and the demand (right side) for central bank money are equal. The money supply, H, refers to the monetary base. The demand for money is the sum of the demand for currency and the demand for reserves by banks (refer to chapter 4 for more detail).

28. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 35 Reserve Requirements Reserve requirements are the minimum amount of reserves that banks must hold in proportion to checkable deposits. By changing reserve requirements, the Fed effectively changes the demand for central bank money. This instrument of monetary policy is not widely used because banks may take drastic actions to increase their reserves, such as recalling some of the loans.

29. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard29 of 35 Lending to Banks The Fed can also lend to banks, thereby affecting the supply of central bank money. The set of conditions under which the Fed lends to banks is called discount policy. The Fed lends at a rate called the discount rate, through the discount window. Today, changes in the discount rate are used mostly as a signal to financial markets.

30. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard30 of 35 Open-Market Operations Open-market operations, the purchase and sale of government bonds in the open market, is the main instrument of U.S. monetary policy. It is convenient and flexible. When the Fed buys bonds, it pays for them by creating money, thereby increasing the money supply, H. When it sells bonds, it decreases H.

31. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard31 of 35 The Implementation of Policy The most important monetary policy decisions are made at meetings of the FOMC. Fed staff prepares forecasts and simulations of the effects of different monetary policies on the economy, and identifies the major sources of uncertainty. The conduct of open-market operations between FOMC meetings is left to the Open Market Desk.

32. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard32 of 35 The Implementation of Policy Does the Fed have an inflation target, or follow an interest rate rule?  The answer is: we don’t know. The Fed chairman, Alan Greenspan, is renowned for his lack of transparency.  The evidence strongly shows that the Fed has in fact an implicit inflation target of about 2-3%. It is also clear that the Fed adjusts the federal funds rate in response both to the inflation rate and to deviations of unemployment from the natural rate.

33. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard33 of 35 The Implementation of Policy Does the Fed have an inflation target, or follow an interest rate rule?  Many economists say: Do not argue with success. So far, the record of monetary policy under Greenspan has been outstanding.  Other economists are more skeptical. They argue that it is unwise to have monetary policy depend so much on one individual, that the next Chairman of the Fed may not be able to achieve the same mix of credibility and flexibility.

34. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard34 of 35 The Implementation of Policy The Federal Funds Rate, 1987-2004 In 1990-1992, and again in 2001, the Fed dramatically decreased the federal funds rate to try to avoid a recession. Figure 25 - 2

35. Chapter 25: Monetary Policy: A Summing Up © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard35 of 35 Key Terms  shoe-leather costs  money illusion  liquid asset  monetary aggregates,  broad money (M2)  inflation targeting  Taylor’s rule  Humphrey-Hawkins Act  Federal Reserve Districts Federal Reserve Districts  Board of Governors Board of Governors  Federal Open Market Committee (FOMC) Federal Open Market Committee (FOMC)  Open Market Desk, Open Market Desk,  reserve requirements  discount policy  discount rate  discount window