Unit 3: Monetary PolicyUnit 3: Monetary Policy

Monetary Policy TargetsMonetary Policy Targets4/5/20114/5/2011

• tools• instruments• targets• goals

Monetary PolicyMonetary Policy

• open market operations• discount rate• required reserve ratio

Monetary Policy ToolsMonetary Policy Tools

• reserve aggregateso reserveso non-borrowed reserveso monetary base

• interest rateso short-term interest rates

federal funds rate

Monetary Policy InstrumentsMonetary Policy Instruments

Monetary Policy InstrumentsMonetary Policy Instruments

policy instrument policy instrument –variable that responds to

tools and indicates the stance(easy or tight) of monetary policy

Monetary Policy TargetsMonetary Policy Targets• monetary aggregates

o M1o M2

• interest rateso inflation rateo long-term interest rateo short-term interest rate

Monetary Policy TargetsMonetary Policy Targets

intermediate target intermediate target –stands between the instruments

and goals of monetary policy

Monetary Policy GoalsMonetary Policy Goals

• price stability• high employment• economic growth• financial market stability• interest-rate stability• foreign exchange stability

Monetary Policy TargetsMonetary Policy Targets

• monetary targeting• inflation targeting• targeting with no nominal anchor

Monetary TargetingMonetary Targeting

monetary targeting monetary targeting –central bank announces targets

for the annual growth rate ofa monetary aggregate

(e.g., 5% growth of M1 or6% growth of M2)

Monetary TargetingMonetary TargetingUnited States• money supply growth targets announced

o Arthur Burns in 1975o often missed targets

• focus on non-borrowed reserveso Paul Volker in 1979

• won’t use monetary aggregates as a guideo Greenspan in 1993

Monetary TargetingMonetary Targeting

Japan• “forecasts” for M2 + CDs announced in 1978• performance better than the Fed 1978-1987• switched to a tighter monetary policy 1989

o partially blamed for the “lost decade”

Monetary TargetingMonetary TargetingGermany• focus on “central bank money” (early 1970s)• can restrain inflation in the longer run

o even when targets are missed• reason for the relative success

o clearly stated monetary policy objectiveso central bank communication with public

Monetary TargetingMonetary Targeting• elements

o flexibleo transparento accountable

• advantageso immediate signals (inflation expectations)o immediate accountability

• disadvantageso strong and reliable relationship required

goal variable : targeted aggregate

Inflation TargetingInflation Targeting• medium-term numerical target for inflation

o public announcement• institutional commitment to price stability

o primary, long-run goal of monetary policy• many variables are used in making decisions• increased transparency of the strategy• increased accountability of the central bank

• New Zealand (since 1990)o inflation decreasedo high growth, lower unemployment

• Canada (since 1991)o inflation decreasedo slightly higher unemployment

• United Kingdom (since 1992)o inflation close to targeto high growth, lower unemployment

Inflation TargetingInflation Targeting

• advantageso more variables examinedo easily understoodo reduces time-inconsistency problemo transparency and accountability

• disadvantageso delayed signalingo too much rigidityo more output fluctuations possibleo less GDP growth during disinflation

Inflation TargetingInflation Targeting

Inflation TargetingInflation Targeting

Inflation TargetingInflation Targeting

Inflation TargetingInflation Targeting

Targeting with no Explicit AnchorTargeting with no Explicit Anchor

• no explicit nominal anchor o no overriding concern for the Fed

• used by the Fed recently• “just do it” approach• forward looking behavior• periodic “preemptive strikes”• goal: prevent inflation from getting started

Targeting with no Explicit AnchorTargeting with no Explicit Anchor• advantages

o uses many sources of informationo reduces time-inconsistency problemo demonstrated success

• disadvantageso lack of transparency and accountabilityo strong dependence on people in charge

preferences, skills, trustworthinesso inconsistent with democratic principles

Monetary Policy StrategiesMonetary Policy Strategies

Interest Rate, i

Quantity of Money, M

Md

Ms*

M*

i* Md

2

Md1

i1

i2

• M d fluctuates between M d

1 and M d2

• With M-target at M*, i fluctuates between i1 and i2

Money Supply TargetMoney Supply Target

Interest Rate TargetInterest Rate TargetInterest Rate, i

Quantity of Money, M

Md

Ms

M*

i* Md

2

Md

1

i1

i2

• M d fluctuates between M d

1 and M d2

• To set i-target at i* Ms fluctuates between M1 and M2

M1*

M1

M2*

M2

Nonborrowed Reserves TargetNonborrowed Reserves TargetFederal Funds

Rate

Quantity of Reserves, R

Rs

Rn

iff1

1

Rd1

id

Rd2

ier

Rd3

iff2

iff3

Federal FundsRate

Rs

Rn1

iff*

1

Rd1

id

Rd2

ier

Rd3

Rn2 Rn

3

Federal Funds Rate TargetFederal Funds Rate Target

Quantity of Reserves, R

Monetary Policy TargetsMonetary Policy TargetsCriteria for choosing targets1.measurability2.controllability3.ability to predictably affect goals

Interest rates aren’t clearly better than Ms on 1 & 2

because hard to measure and control real interest rates.

Criteria for choosing instruments1.measurability2.controllability3.ability to predictably affect targets

Monetary Policy InstrumentsMonetary Policy Instruments

Reserve aggregates and interest rates about equal on 1 & 2.

If intermediate target is Ms, then reserve aggregate is better for 3.

Fed Policy ProceduresFed Policy Procedures

Early years of the Fed (1913-1921)• discount loans the primary policy• real bills doctrine

o thoroughly discredited

Fed Policy ProceduresFed Policy Procedures

Discovery of OMO (1921-1929)• Federal Reserve needed more revenue• invested in income earning securities• open market operations

o accidentally discovered

Fed Policy ProceduresFed Policy ProceduresGreat Depression (1929-1941)• raised discount rate too late

o wanted to temper stock boomo but worried about hurting others

• bank failures reduced money supplyo Fed didn’t understando M1 contracted 25%o Fed believed was expanding Ms

• Fed didn’t act as LOLR

Fed Policy ProceduresFed Policy ProceduresReserve requirements (1933-1941)• Fed got reserve requirements power

o Agricultural Adjustment Act of 1933• Fed RR power expanded

o Banking Act of 1935• excess reserves hurt monetary policy• raised reserve requirements for control

o Aug. 1936, Jan. 1937, May 1937o caused 1937-1938 recessiono “double dip” of Great Depression

Fed Policy ProceduresFed Policy ProceduresPegging of interest rates (1942-1951)• skyrocketed government spending

o wanted to finance WWII cheaply• pegged interest rates

o Treasury bills: 3/8%o Treasury bonds: 2.5%

• if interest rates on bonds roseo Fed made open market purchaseso interest rates would then fall

• rapid growth in MB & money supply

Fed Policy ProceduresFed Policy ProceduresTargeting money market (1950s, 1960s)• intuitive judgment

o based on feel for money marketo i.e., interest rates

• William Martin was Fed chairman• pro-cyclical policy (for M)

o Y↑ → i↑ → MB↑ → M↑o π↑ → πe↑ → i↑ → MB↑ → M↑o monetarists criticized (e.g., Friedman)

DefinitionsDefinitionsprocyclical procyclical –

economic quantity positively correlatedwith state of the economy;

up during booms, down during busts

countercyclical countercyclical –economic quantity negatively correlated

with state of the economy;down during booms, up during busts

Fed Policy ProceduresFed Policy ProceduresTargeting monetary aggregates (1970s)• wasn’t really monetary targeting

o actually used fed funds rate• Arthur Burns was Fed chairman• still pro-cyclical policy (for M)

o Y↑ → i↑ → MB↑ → M↑o π↑ → πe↑ → i↑ → MB↑ → M↑o monetarists criticized (e.g., Friedman)

Fed Policy ProceduresFed Policy ProceduresNew operating procedures (1979-1982)• de-emphasis on fed funds rate• non-borrowed reserves main instrument• still used interest rates• Paul Volcker was Fed chair• not serious about monetary aggregates

o avoided blame for high interest rates• anti-inflation strategy

Fed Policy ProceduresFed Policy ProceduresDe-emphasis of M aggregates (1982-1993)• de-emphasis of monetary aggregates• borrowed reserves main instrument

o discount loans• pro-cyclical policy (for M)

o Y↑ → i↑ → DL↑ → MB↑ → M↑• breakdown in M:GDP relationship

Fed Policy ProceduresFed Policy Procedures

Federal funds targeting again (1993-present)• monetary aggregates no longer used

o Greenspan testified before Congress• federal funds rate main instrument/target

o FFR target announced starting 1994

Fed Policy ProceduresFed Policy ProceduresOther considerations• pre-emptive strikes against inflation

o 1994, 1999, 2004• pre-emptive strikes against recessions

o 1996, 1998, 2001, 2007o 1998: Long Term Capital Management

• international considerationso M↑ in 1985 to lower exchange rateo M↓ in 1987 to raise exchange rate

Active vs. Passive PolicyActive vs. Passive PolicyAdvantages of Active Policy• recessions cause economic• Employment Act of 1946

o “It is the continuing policy and responsibility of the Federal Government to … promote full employment and production.”

• AD-AS modelo monetary policy can stabilize economyo fiscal policy can stabilize economy

Active vs. Passive PolicyActive vs. Passive PolicyAdvantages of Passive Policy• long & variable lags to policies

o Milton Friedman emphasized thiso inside (implementation) lag

time between shock and response takes time to recognize shock takes time to implement policy

o outside (effectiveness) lag time it takes policy to affect economy

o may de-stabilize when takes effect

Active vs. Passive PolicyActive vs. Passive Policyautomatic stabilizers automatic stabilizers –

policies that stimulate or depress the economy when necessary without any

deliberate policy change(designed to reduce lags)

Automatic stabilizer examples• income tax• unemployment insurance• welfare

ForecastingForecastingBecause policies act with lags, policymakers

must predict future conditions.Generating forecasts• leading economic indicators

o data series fluctuating before economyo Index of Leading Economic Indicators

includes 10 data series • macroeconometric models

o large models w/ estimated parameterso forecasts response to shocks & policies

ForecastingForecasting

-10

-5

0

5

10

15

20

1960 1962 1964 1966 1968 1970

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators Real GDP

ForecastingForecasting

-20

-15

-10

-5

0

5

10

15

20

1970 1972 1974 1976 1978 1980

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators Real GDP

ForecastingForecasting

-20

-15

-10

-5

0

5

10

15

20

1980 1982 1984 1986 1988 1990

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators Real GDP

-15

-10

-5

0

5

10

15

1990 1992 1994 1996 1998 2000 2002

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators Real GDP

ForecastingForecasting

Une

mpl

oym

ent

rate

ForecastingForecasting

Stan

dard

dev

iatio

n

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Volatility

of GDP

Volatility of

Inflation

StabilityStability

Rules vs. DiscretionRules vs. Discretionrules rules –

policymakers announce in advance how policy will respond in various situations,

and commit themselves to following through

discretion discretion –as events occur and circumstances change, policymakers use their judgment and apply

whatever policies seem appropriate at the time

Rules vs. DiscretionRules vs. DiscretionArguments for rules• distrust of policymakers & political process

o misinformed politicianso politicians & society interests different

• time inconsistencyo destroys policymaker credibility

time inconsistency time inconsistency –policymakers have an incentive to renege on a

previously announced policy once others act

Monetary Policy RulesMonetary Policy Rules

• constant money supply growth rate• target growth rate of nominal GDP• target the inflation rate• the Taylor Rule

Monetary Policy RulesMonetary Policy Rules

Constant money supply growth rate• advocated by monetarists• stabilizes AD only if velocity is stable• Friedman k-percent rule

o 4% per yearo gM + gV = gP + gyo gP = 0, gV = -1%, gy = 3%, k% = gM= 4%

Monetary Policy RulesMonetary Policy Rules

Target growth of nominal GDP• automatic• increase money growth

o when nominal GDP grows under target• decrease money growth

o when nominal GDP growth over target

Monetary Policy RulesMonetary Policy RulesTarget the inflation rate• automatic• decrease money growth

o when inflation rate over target• increase money growth

o when inflation rate below target• many countries practice inflation targeting

o but allow a little discretion

Monetary Policy RulesMonetary Policy RulesThe Taylor Rule• automatic• target the federal funds rate• based on

o inflation rateo GDP gap (actual & full-employment)o inflation gap (actual & target)

• proposed by John Taylor

Taylor RuleTaylor Ruleiff = inflation rate + equilibrium real fed funds rate target + 0.5(inflation gap) + 0.5(GDP gap)

• iff ≡ nominal federal funds rate target• π ≡ inflation rate• equilibrium real federal funds rate = 2• inflation gap = π – 2• GDP gap = 100(y – yn)/yn

o percent real GDP is below natural rate

Taylor RuleTaylor Rule

iff = π + 2 + 0.5(π – 2) + 0.5(GDP gap)

• if π = 2% & y = yn, iff = 4%• π↑ by 1% → iff↑ by 1.5%• (y – yn)↑ by 1% → iff↑ by 0.5%

Taylor RuleTaylor RulePe

rcen

t

0

2

4

6

8

10

12

1987 1990 1993 1996 1999 2002 2005

Taylor’s Rule

Actual