© 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando...

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

2525C H A P T E RC H A P T E R

Monetary Policy:Monetary Policy:A Summing UpA Summing Up

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

The Optimal Inflation RateThe Optimal Inflation Rate25-1

Inflation has steadily gone down in rich Inflation has steadily gone down in rich countries since the early 1980s.countries since the early 1980s.

The attempt to reduce it even further depends The attempt to reduce it even further depends on the costs and benefits of inflation.on the costs and benefits of inflation.

Table 25-1 Inflation Rates in the OECD, 1981-2000

1981 1985 1990 1995 2000

OECD average (%)*OECD average (%)* 10.510.5 6.66.6 6.26.2 5.25.2 2.52.5

Number of countries with Number of countries with inflation below 5%**inflation below 5%** 22 1010 1515 2121 2424

* Average of GDP deflator inflation rates, using GDPs at PPP prices as weights.* Average of GDP deflator inflation rates, using GDPs at PPP prices as weights.**Out of 30 countries.**Out of 30 countries.


The Costs of InflationThe Costs of Inflation

Shoe-leather costsShoe-leather costs are the costs of making are the costs of making more trips to the bank in the presence of more trips to the bank in the presence of inflation. They reflect an increase in the inflation. They reflect an increase in the opportunity cost of holding money.opportunity cost of holding money.

Tax distortionsTax distortions occur when tax rates do not occur when tax rates do not increase automatically with inflation, a concept increase automatically with inflation, a concept known as bracket creep. Income for purposes known as bracket creep. Income for purposes of taxation includes nominal interest of taxation includes nominal interest payments, not real interest payments.payments, not real interest payments.


The Costs of InflationThe Costs of Inflation

Money illusionMoney illusion is the cost of inflation is the cost of inflation associated with the notion that people make associated with the notion that people make systematic mistakes in assessing nominal systematic mistakes in assessing nominal versus real changes, leading people to make versus real changes, leading people to make incorrect decisions.incorrect decisions.

Inflation variabilityInflation variability means that financial assets means that financial assets such as bonds, which promise fixed nominal such as bonds, which promise fixed nominal payments in the future, become riskier.payments in the future, become riskier.


The Benefits of InflationThe Benefits of Inflation

SeignorageSeignorage, or the revenues from money , or the revenues from money creation, allow the government to borrow less creation, allow the government to borrow less from the public, or to lower taxes.from the public, or to lower taxes.

An economy with a higher average inflation An economy with a higher average inflation rate has more scope to use monetary policy to rate has more scope to use monetary policy to fight a recession.fight a recession.

The presence of inflation allows for downward The presence of inflation allows for downward real-wage adjustments more easily than when real-wage adjustments more easily than when there is no inflation.there is no inflation.


The Optimal Inflation Rate:The Optimal Inflation Rate:The Current DebateThe Current Debate

Those who aim for small but positive inflation Those who aim for small but positive inflation argue that some of the costs of positive argue that some of the costs of positive inflation can be avoided, and the benefits are inflation can be avoided, and the benefits are worth keeping.worth keeping.

Those who aim for zero inflation argue that Those who aim for zero inflation argue that this amounts to price stability, which simplifies this amounts to price stability, which simplifies decisions and eliminates money illusion.decisions and eliminates money illusion.

Today, most central banks appear to be Today, most central banks appear to be aiming for a low but positive inflation, between aiming for a low but positive inflation, between 2 and 4%.2 and 4%.


The Design ofThe Design of Monetary Policy Monetary Policy

25-2

The choice of an optimal inflation rate The choice of an optimal inflation rate determines the rate of nominal money growth.determines the rate of nominal money growth.

g gm y

The central bank may want to announce a The central bank may want to announce a target for nominal money growth, and make it target for nominal money growth, and make it clear how it would deviate from it to address clear how it would deviate from it to address short-run fluctuations.short-run fluctuations.

Until recently, this is how monetary policy has Until recently, this is how monetary policy has been conducted in most countries.been conducted in most countries.


Money Growth and Inflation RevisitedMoney Growth and Inflation Revisited

The design of monetary policy around nominal The design of monetary policy around nominal money growth is based on the assumption money growth is based on the assumption that a close relation between inflation and that a close relation between inflation and nominal money growth exists in the medium nominal money growth exists in the medium run.run.

The problem is that this relation is not very The problem is that this relation is not very tight.tight.


M1 Growth and InflationM1 Growth and Inflation

M1 Growth and Inflation: M1 Growth and Inflation: 10-year averages, 10-year averages, 1970-20001970-2000

There is no tight relation There is no tight relation between between M1M1 growth and growth and inflation, not even in the inflation, not even in the medium run.medium run.


From From M1M1 to to M2M2, , M3M3,,and Other Monetary Aggregatesand Other Monetary Aggregates

The relation between The relation between M1M1 growth and inflation is growth and inflation is not tighter because of shifts in the demand for not tighter because of shifts in the demand for money.money.

Many financial assets are very Many financial assets are very liquidliquid, which , which makes them attractive as substitutes for money. makes them attractive as substitutes for money. However, these assets are not included in However, these assets are not included in M1M1..

When people reduce their bank account When people reduce their bank account balances and move to money market funds, balances and move to money market funds, there is a negative shift in the demand for there is a negative shift in the demand for money.money.


From From M1M1 to to M2M2, , M3M3,,and Other Monetary Aggregatesand Other Monetary Aggregates

Measures that include not only money but other Measures that include not only money but other liquid assets are called liquid assets are called monetary aggregatesmonetary aggregates, , under the name of under the name of M2M2, , M3M3, and so on., and so on.

In the United States, In the United States, M2M2 is also called is also called broad broad moneymoney..

The central bank could choose The central bank could choose M2M2 growth as growth as target, however,target, however, The relation between M2 growth and inflation is not The relation between M2 growth and inflation is not

very tight either, andvery tight either, and The central bank does not control The central bank does not control M2M2..


M2M2 Growth Target Growth TargetRange and RealizationRange and Realization

M2 Growth and Inflation: M2 Growth and Inflation: 10-year averages, 10-year averages, 1970-20001970-2000

While the relation While the relation between M2 growth and between M2 growth and inflation is tighter than inflation is tighter than the relation between M1 the relation between M1 growth and inflation, it is growth and inflation, it is still not very tight.still not very tight.


M2M2 Growth Target Growth TargetRange and RealizationRange and Realization

M2 Growth, 1975-2000: M2 Growth, 1975-2000: Actual Growth Rate and Actual Growth Rate and Target Growth RangeTarget Growth Range

Actual Actual M2M2 growth has growth has ended out of the target ended out of the target range for 11 out of the range for 11 out of the last 25 years.last 25 years.

Since the Fed had Since the Fed had missed the target so missed the target so much, the Fed has much, the Fed has decided not to announce decided not to announce a target range for a target range for M2M2 after the year 2000.after the year 2000.


Inflation TargetingInflation Targetingand Interest Rate Rulesand Interest Rate Rules

Many central banks have defined as their Many central banks have defined as their primary, and sometimes exclusive goal, the primary, and sometimes exclusive goal, the achievement of a low inflation rate. This is achievement of a low inflation rate. This is known as known as inflation targetinginflation targeting..

Inflation targeting would lead the central bank Inflation targeting would lead the central bank to act in such a way as to eliminate all to act in such a way as to eliminate all deviations of output from the natural level of deviations of output from the natural level of output.output.


, then the central , then the central bank should set bank should set iitt equal to its target value, equal to its target value, ii*.*.

Taylor’s RuleTaylor’s Rule

According to Taylor, since it is the interest rate According to Taylor, since it is the interest rate that directly affects spending, the central bank that directly affects spending, the central bank should choose an interest rate rather than a should choose an interest rate rather than a rate of nominal money growth.rate of nominal money growth.

i i b u ut te

t n * a( ) ( )

If If t t 1 u ut nandand



The higher the value of The higher the value of aa, the more the central , the more the central bank will increase the interest rate in response bank will increase the interest rate in response to inflation.to inflation.

The higher the value of The higher the value of bb, the more the central , the more the central bank will be willing to deviate from target bank will be willing to deviate from target inflation to keep unemployment close to the inflation to keep unemployment close to the natural rate.natural rate.

In sum, these coefficients reflect how much the In sum, these coefficients reflect how much the central bank cares about unemployment versus central bank cares about unemployment versus inflation.inflation.

i i b u ut te

t n * a( ) ( )



Taylor’s rule provides a way of thinking about Taylor’s rule provides a way of thinking about monetary policy: once the central bank has monetary policy: once the central bank has chosen a target rate of inflation, it should try to chosen a target rate of inflation, it should try to achieve it by adjusting the nominal interest rate.achieve it by adjusting the nominal interest rate.

This rule actually describes quite well the This rule actually describes quite well the behavior of central banks in the past 15-20 behavior of central banks in the past 15-20 years.years.

i i b u ut te

t n * a( ) ( )


The Fed in ActionThe Fed in Action

The mandate of the The mandate of the Federal Reserve SystemFederal Reserve System was most recently defined in the was most recently defined in the Humphrey-Humphrey-Hawkins ActHawkins Act, passed by Congress in 1978., passed by Congress in 1978.

For more information on how the Fed is For more information on how the Fed is organized, go to the Fed’s Web site:organized, go to the Fed’s Web site:

www.federalreserve.gov/

25-3


The Organization of the FedThe Organization of the Fed

The Federal Reserve System is composed of The Federal Reserve System is composed of three parts:three parts: A set of 12 A set of 12 Federal Reserve DistrictsFederal Reserve Districts The The Board of GovernorsBoard of Governors The The Federal Open Market Committee Federal Open Market Committee

(FOMC)(FOMC) and the and the Open Market DeskOpen Market Desk..


The Instruments of Monetary PolicyThe Instruments of Monetary Policy

The equilibrium interest rate is the interest The equilibrium interest rate is the interest rate at which the supply (left side) and the rate at which the supply (left side) and the demand (right side) for central bank money demand (right side) for central bank money are equal.are equal.

The money supply, The money supply, HH, refers to the monetary , refers to the monetary base. The demand for money is the sum of base. The demand for money is the sum of the demand for currency and the demand for the demand for currency and the demand for reserves by banks (refer to chapter 4 for more reserves by banks (refer to chapter 4 for more detail).detail).

H c c YL i [ ( )]$ ( ) 1


Reserve RequirementsReserve Requirements

Reserve requirementsReserve requirements are the minimum are the minimum amount of reserves that banks must hold in amount of reserves that banks must hold in proportion to checkable deposits.proportion to checkable deposits.

By changing reserve requirements, the Fed By changing reserve requirements, the Fed effectively changes the demand for central effectively changes the demand for central bank money.bank money.

This instrument of monetary policy is not This instrument of monetary policy is not widely used because banks may take drastic widely used because banks may take drastic actions to increase their reserves, such as actions to increase their reserves, such as recalling some of the loans.recalling some of the loans.


Lending to BanksLending to Banks

The Fed can also lend to banks, thereby The Fed can also lend to banks, thereby affecting the supply of central bank money.affecting the supply of central bank money.

The set of conditions under which the Fed The set of conditions under which the Fed lends to banks is called lends to banks is called discount policydiscount policy. The . The Fed lends at a rate called the Fed lends at a rate called the discount ratediscount rate, , through the through the discount windowdiscount window..

Today, changes in the discount rate are used Today, changes in the discount rate are used mostly as a signal to financial markets.mostly as a signal to financial markets.


Open-Market OperationsOpen-Market Operations

Open-market operations, the purchase and Open-market operations, the purchase and sale of government bonds in the open market, sale of government bonds in the open market, is the main instrument of U.S. monetary policy. is the main instrument of U.S. monetary policy. It is convenient and flexible.It is convenient and flexible.

When the Fed buys bonds, it pays for them by When the Fed buys bonds, it pays for them by creating money, thereby increasing the money creating money, thereby increasing the money supply, supply, HH. When it sells bonds, it decreases . When it sells bonds, it decreases HH..


The Practice of PolicyThe Practice of Policy

The most important monetary policy decisions The most important monetary policy decisions are made at meetings of the FOMC.are made at meetings of the FOMC.

Fed staff prepares forecasts and simulations Fed staff prepares forecasts and simulations of the effects of different monetary policies on of the effects of different monetary policies on the economy, and identifies the major sources the economy, and identifies the major sources of uncertainty.of uncertainty.

The conduct of open-market operations The conduct of open-market operations between FOMC meetings is left to the Open between FOMC meetings is left to the Open Market Desk.Market Desk.



Does the Fed have an inflation target, or follow Does the Fed have an inflation target, or follow an interest rate rule? The answer is: we don’t an interest rate rule? The answer is: we don’t know. The Fed chairman, Alan Greenspan, is know. The Fed chairman, Alan Greenspan, is renowned for his lack of transparency.renowned for his lack of transparency.

The evidence strongly shows that the Fed has in The evidence strongly shows that the Fed has in fact an implicit inflation target of about 3%. It is fact an implicit inflation target of about 3%. It is also clear that the Fed adjusts the federal funds also clear that the Fed adjusts the federal funds rate in response both to the inflation rate and to rate in response both to the inflation rate and to deviations of unemployment from the natural deviations of unemployment from the natural rate.rate.



The Federal Funds The Federal Funds Rate, 1987-2001Rate, 1987-2001

In 1990-1992, and In 1990-1992, and again in 2001, the again in 2001, the Fed dramatically Fed dramatically decreased the decreased the federal funds rate federal funds rate to try to avoid a to try to avoid a recession.recession.


Key TermsKey Terms

shoe-leather costs,shoe-leather costs, money illusion,money illusion, liquid asset,liquid asset, monetary aggregates,monetary aggregates, broad money (M2),broad money (M2), inflation targeting,inflation targeting, Taylor’s rule,Taylor’s rule, Humphrey-Hawkins Act,Humphrey-Hawkins Act,

Federal Reserve Districts, Board of Governors, Federal Open Market Committ

ee (FOMC), Open Market Desk, reserve requirements, discount policy, discount rate, discount window,

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