Objectives

Distinguish among the instruments, ultimate goals, and intermediate targets of monetary policy and review the Fed’s performance

Describe and compare the performance of a monetarist fixed rule and Keynesian feedback rules for monetary policy

Explain why the outcome of monetary policy crucially depends on the Fed’s credibility

Describe and compare the new monetarist and new Keynesian feedback rules for monetary policy

What Can Monetary Policy Do?

In 2001, real GDP shrank and the unemployment rate increased.

Alan Greenspan cut the interest rate to stimulate production and jobs.

Were these actions the right ones?

Can and should monetary policy try to counter recessions?

Or should monetary policy focus on price stability?

Instruments, Goals, Targets, and the Fed’s Performance

To discuss monetary policy we distinguish among:

Instruments

Goals

Intermediate targets

Instruments, Goals, Targets, and the Fed’s Performance

The instruments of monetary policy are

Open market operations

The discount rate

Required reserve ratios

The goals of monetary policy are the Fed’s ultimate objectives and are

Price level stability

Sustainable real GDP growth close to potential GDP

Instruments, Goals, Targets, and the Fed’s Performance

The Fed’s instruments work with an uncertain, long, and variable time lag.

To assess its actions, the Fed watches intermediate targets.

The possible intermediate targets are

Monetary aggregates (M1 and M2, the monetary base)

The federal funds rate

The Fed’s current intermediate target is the federal funds rate.

Instruments, Goals, Targets, and the Fed’s Performance

Price Level Stability

Unexpected swings in the inflation rate bring costs for borrowers and lenders and employers and workers.

What Is Price Level Stability?

Alan Greenspan defined price level stability as a condition in which the inflation rate does not feature in people’s economic calculations.

An inflation rate between 0 and 3 percent a year is generally seen as being consistent with price level stability.

Instruments, Goals, Targets, and the Fed’s Performance

Sustainable Real GDP Growth

Natural resources and the willingness to save and invest in new capital and new technologies limit sustainable growth.

Monetary policy can contribute to potential GDP growth by creating a climate that favors high saving and investment rates.

Monetary policy can help to limit fluctuations around potential GDP.

Instruments, Goals, Targets, and the Fed’s Performance

The Fed’s Performance: 1973–2003

The Fed’s performance depends on

Shocks to the price level

Monetary policy actions

Instruments, Goals, Targets, and the Fed’s Performance

Shocks to the price level during the 1970s and 1980s made the Fed’s job harder

World oil price hikes

Large and increasing budget deficits

Productivity slowdown

These shocks intensified inflation and slowed real GDP growth.

Instruments, Goals, Targets, and the Fed’s Performance

Shocks in the 1990s made the Fed’s job easier.

Falling world oil prices

Decreasing budget deficits (and eventually a budget surplus)

New information economy brought more rapid productivity growth.

Instruments, Goals, Targets, and the Fed’s Performance

Figure 16.1 summarizes monetary policy 1973-2003.

Instruments, Goals, Targets, and the Fed’s Performance

There is a tendency for the federal funds rate to fall as an election approaches and usually the incumbent President or his party’s successor wins the election.

Two exceptions

In 1980, interest rates increased, the economy slowed, and Jimmy Carter lost his reelection bid.

In 1992, interest rates increased, and George Bush lost his reelection bid.

Instruments, Goals, Targets, and the Fed’s Performance

Presidents take a keen interest in what the Fed is up to.

And as the 2004 election approached, the White House was watching anxiously, hoping that the Fed would continue to favor a low federal funds rate and keep the economy expanding.

Instruments, Goals, Targets, and the Fed’s Performance

Figure 16.2 provides a neat way of showing how well the Fed has done in shooting at its target.

Achieving Price Level Stability

There are two price level problems

When the price level is stable, the problem is to prevent inflation from breaking out.

When inflation is already present, the problem is to reduce its rate and restore price level stability while doing the least possible damage to real GDP growth.

Achieving Price Level Stability

The monetary policy regimes that can be used to stabilize aggregate demand are

Fixed-rule policies

Feedback-rule policies

Discretionary policies

Achieving Price Level Stability

Fixed-Rule Policies

A fixed-rule policy specifies an action to be pursued independently of the state of the economy.

An everyday example of a fixed rule is a stop sign--“Stop regardless of the state of the road ahead.”

A fixed-rule policy proposed by Milton Friedman is to keep the quantity of money growing at a constant rate regardless of the state of the economy.

Achieving Price Level Stability

Feedback-Rule Policies

A feedback-rule policy specifies how policy actions respond to changes in the state of the economy.

A yield sign is an everyday feedback rule—“Stop if another vehicle is attempting to use the road ahead, but otherwise, proceed.”

A monetary policy feedback-rule is one that pushes the interest rate ever higher in response to rising inflation and strong real GDP growth and ever lower in response to falling inflation and recession.

Achieving Price Level Stability

Discretionary Policies

A discretionary policy responds to the state of the economy in a possibly unique way that uses all the information available, including perceived lessons from past “mistakes.”

An everyday discretionary policy occurs at an unmarked intersection--each driver uses discretion in deciding whether to stop and how slowly to approach.

Most macroeconomic policy actions have an element of discretion because every situation is to some degree unique.

Achieving Price Level Stability

Policy Lags and the Forecast Horizon

The effects of policy actions taken today are spread out over the next two years or even more.

The Fed cannot forecast that far ahead.

The Fed can’t predict the precise timing and magnitude of the effects of its policy actions.

A feedback policy that reacts to today’s economy might be wrong for the economy at that uncertain future date when the policy’s effects are felt.

Policy Credibility

A policy that is credible works much better than one that surprises.

Contrast two cases

A surprise inflation reduction

A credible announced inflation reduction

Policy Credibility

A Surprise Inflation Reduction

Figure 16.8(a) shows the economy at full employment on aggregate demand curve AD0 and short-run aggregate supply curve SAS0.

Real GDP is $10 trillion, and the price level is 105.

Policy Credibility

The expected inflation rate is 10 percent.

So next year, aggregate demand is expected to be AD1 and the money wage rate increases to shift the short-run aggregate supply curve SAS1.

Policy Credibility

If expectations are fulfilled, the price level rises to 115.5—a 10 percent inflation—and real GDP remains at potential GDP.

Now suppose that the Fed unexpectedly decides to slow inflation.

Policy Credibility

The Fed raises the interest rate and slows aggregate demand growth.

The aggregate demand curve shifts rightward to AD2.

Real GDP decreases to $9.5 trillion, and the price level rises to 113.4—an inflation rate of 8 percent a year.

Policy Credibility

The Fed’s policy has succeeded in slowing inflation, but at the cost of recession.

Real GDP is below potential GDP, and unemployment is above its natural rate.

Policy Credibility

A Credible Announced Inflation Reduction

Suppose the Fed announces its intention to slow inflation to 5 percent.

Suppose also that the Fed’s policy announcement is credible and convincing.

The expected inflation rate becomes 5 percent a year.

Policy Credibility

In Figure 16.8(a), the SAS curve shifts to SAS2.

Aggregate demand increases by the amount expected, and the aggregate demand curve shifts to AD2.

The price level rises to 110.25—inflation is 5 percent—and real GDP remains at potential GDP.

Policy Credibility

In Figure 16.8(b), the lower expected inflation rate shifts the short-run Phillips curve downward to SRPC1, and inflation falls to 5 percent a year, while unemployment remains at its natural rate of 6 percent.

Policy Credibility

A credible announced inflation reduction lowers inflation but with no accompanying recession or increase in unemployment.

Policy Credibility

Inflation Reduction in Practice

When the Fed in fact slowed inflation in 1981, we paid a high price.

The Fed’s policy action to end inflation was not credible.

Could the Fed have lowered inflation without causing recession by telling people far enough ahead of time that it did indeed plan to lower inflation?

The answer appears to be no.

People expect the Fed to behave in line with its record, not with its stated intentions.

New Monetarist and New Keynesian Feedback Rules

A monetarist rule

Prevents cost-push inflation at the cost of recession

Brings price level fluctuations in the face of productivity shocks

Brings price level and real GDP fluctuations in the face of aggregate demand fluctuations

New Monetarist and New Keynesian Feedback Rules

A Keynesian feedback rule that targets real GDP

Brings cost-push inflation

Might not moderate fluctuations in the price level and real GDP that stem from aggregate demand shocks

A Keynesian feedback rule that targets the price level

Prevents cost-push inflation but at an even greater cost of recession than that of a monetarist fixed rule.

New Monetarist and New Keynesian Feedback Rules

None of these rules work well, and none is a sufficiently credible rule for the Fed to commit to.

In an attempt to develop a rule that is credible and that works well, economists have explored policies that respond to both the price level and real GDP.

Two such policy rules are the

McCallum Rule

Taylor Rule

New Monetarist and New Keynesian Feedback Rules

The McCallum Rule

Suggested by Bennett T. McCallum, an economics professor at Carnegie-Mellon University, the McCallum rule says

Make the monetary base grow at a rate equal to the target inflation rate plus the 10-year moving average growth rate of real GDP minus the 4-year moving average of the growth rate of the velocity of circulation of the monetary base.

New Monetarist and New Keynesian Feedback Rules

If the Fed had a specific target for the inflation rate, the McCallum rule would tell the Fed the growth rate of monetary base that would achieve that target, on the average.

Figure 16.9 on the next slide shows how the monetary base has grown and how it would have grown if it had followed the McCallum rule.

New Monetarist and New Keynesian Feedback Rules

New Monetarist and New Keynesian Feedback Rules

The Taylor Rule

Suggested by John Taylor, formerly an economics professor at Stanford University and now Undersecretary of the Treasury for International Affairs in the Bush administration, the Taylor rule says

Set the federal funds rate equal to the target inflation rate plus 2.5 percent plus one half of the gap between the actual inflation rate and the target inflation rate plus one half of the percentage deviation of real GDP from potential GDP.

New Monetarist and New Keynesian Feedback Rules

Figure 16.10 shows the federal funds rate and the rate if the Taylor rule were followed.

New Monetarist and New Keynesian Feedback Rules

Differences Between the Rules

The McCallum rule and the Taylor rule tell a similar story about the inflation of the 1970s and the price level stability of the 1990s and 2000s.

During the 1970s, the quantity of money grew too rapidly (McCallum rule) and the federal funds rate was too low (Taylor rule).

New Monetarist and New Keynesian Feedback Rules

Differences Between the Rules

During the 1990s and 2000s, both the growth rate of the quantity of money (McCallum rule) and the federal funds rate (Taylor rule) were consistent with low inflation and price level stability.

But the two rules differ in two important ways

Strength of response to output fluctuations

Targeting money versus the interest rate

New Monetarist and New Keynesian Feedback Rules

Choosing Between the Rules

Monetarists favor targeting the monetary base because they believe that it provides a more solid anchor for the price level than does the interest rate.

Keynesians say that targeting the quantity of money would bring excessive swings in the interest rate, which in turn would bring excessive swings in aggregate expenditure.

For this reason, Keynesians favor interest rate targeting.