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Money and Banking
Advanced Topics Advanced Topics in in
Monetary Policy: Monetary Policy: Central-Bank Independence
and Rules vs. Discretion
Mr. Vaughan
Central-Bank IndependenceCentral-Bank Independence
Factors making Fed independent:Factors making Fed independent:• Governors’ terms are long and staggered.• Chairman’s term overlaps President’s terms.• Reserve Bank presidents are appointed by
District boards of directors.• Funding is independent of political process—
most important factormost important factor.
How is the Fed funded?How is the Fed funded?
• Most Fed income is interest on U.S. government securities acquired through open-market operations.
• Other sources of income include:– fees received for services provided to depository
institutions– interest on discount loans to depository institutions
• The Fed pays expenses and turns the remainder over to the Treasury.
• About 95 percent of Fed earnings have been paid into the Treasury since 1914.
Central-Bank IndependenceCentral-Bank Independence
Factors making Fed dependent:Factors making Fed dependent:• President appoints Chairman and Governors.• “Low” governor salaries prompt high turnover.• Congress can amend Fed legislation.
Overall, Fed is quite independent!
Should the Fed be independent?Should the Fed be independent?
Case for independenceCase for independence::• Monetary policy will reflect the long-term
good of the country.– Inflation rate will be lower. Inflation rate will be lower.
• Monetary policy will not induce political business cycles.
• Monetary policy will impose fiscal discipline on Congress and the President.
Should the Fed be independent?Should the Fed be independent?
Case against independenceCase against independence::• Fed structure is anti-democratic.
• Fed may pursue its own interest, not that of the country.
• Fed performance will be dependent on personalities (and, thus, inconsistent).
• Fed structure will hinder coordination of monetary and fiscal policy.
Central-Bank Independence:Central-Bank Independence: Cross-Country EvidenceCross-Country Evidence
Central bank independence produces(?) lower inflation rates.Central bank independence produces(?) lower inflation rates.
Rules vs. DiscretionRules vs. Discretion
Definitions:Definitions: “Rule-type policymaking involves implementation in each period (or in each case) of a formula designed to apply to periods (or cases) in general, while discretionary policymaking involves freshly made decisions in each period or case.”
Bennett McCallumBennett McCallumMonetary Economics:
Theory and Policy
Case for DiscretionCase for Discretion
Discretion gives policymakers maximum flexibility to react creatively to new policy problems.
– Example:Example: Fed response to 9/11
Activist vs. Non-activist RulesActivist vs. Non-activist Rules
• Non-Activist RuleNon-Activist Rule:: No feedback from economy
Example: M2t = 0.03 (i.e., 3% per annum growth in all states of the world)
• Activist RuleActivist Rule:: includes feedback from economy
Example: M2t = 0.03 + (unemployment ratet-1 – 0.05)
Old Case for RulesOld Case for Rules
1.1. FriedmanFriedman:: Long and variable lags make “fine tuning” impossible.
• Recognition lag• Action lag• Impact lag
2.2. BuchananBuchanan:: Public-choice angle• Without rules, agency problem develops (i.e.,
central bank will pursue its interest at expense of general public)
New Case for Rules:New Case for Rules:Time InconsistencyTime Inconsistency
Discretionary policy has an inflationary biasDiscretionary policy has an inflationary bias.. • Policymakers play game against public.• Public understands policymakers’ incentives.• Without rules, policymaker is tempted to say one thing
and do another; public knows this and discounts “cheap talk.”
• End resultEnd result:: Higher inflation, no gain in unemployment.
To see this, we must take a detour into NAIRU!
Basic StoryBasic Story::• In the long run, unemployment is moored at “natural
rate.”• Unexpectedly high money growth can temporarily
reduce unemployment rate below natural rate. • Only repeated money surprises can keep
unemployment rate below natural rate.
NoteNote: NAIRU is just another name for “natural rate.”
NAIRU FrameworkNAIRU FrameworkNNon-on-AAccelarating ccelarating IInflation nflation RRate of ate of UUnemploymentnemployment
Even when economy is growing at long-term potential, some people remain unemployed.
• Frictional UnemploymentFrictional Unemployment:: due to imperfect information in the labor market
• Structural UnemploymentStructural Unemployment:: due to job/skill mismatch
NAIRU Framework:NAIRU Framework:Natural Rate of UnemploymentNatural Rate of Unemployment
NAIRU FactsNAIRU Facts::• Equilibrium level of unemployment • Not observable • Not constant over time
(affected by demographics, labor market frictions)(affected by demographics, labor market frictions)
• Currently thought to be just above 5%.
NAIRU Framework:NAIRU Framework:Natural Rate of UnemploymentNatural Rate of Unemployment
Point A: •Inflation fully expected and reflected in nominal wage growth.
Infactual = Infexpected = Inf1
•Actual unemployment rate = Natural rate of unemployment
Unemployment Rate
Inflation Rate
Inf1
Un=U1
A
NAIRU Framework:NAIRU Framework:In PicturesIn Pictures
B
U2
Inf2Now, central bank unexpectedly speeds up monetary growth. •Economy perks up.
•Unemployment falls to U2.
•Inflation rises to inf2 .
Unemployment Rate
Inflation Rate
Inf1
A
NAIRU FrameworkNAIRU FrameworkIn PicturesIn Pictures
Un=U1
Why does unemployment fall?Why does unemployment fall?• Workers agreed to nominal wage contracts expecting
inflation to be infinf11.
• Inflation rate ends up somewhat higher at infinf22.
• Firms increase demand for labor because actualactual real wage has fallen.
NAIRU FrameworkNAIRU Framework
NAIRU framework can explain short-run non-neutrality of money!
Drop in unemployment is temporaryDrop in unemployment is temporary::• Over time, workers figure out inflation rate is higher /
real wages are lower than expected. • Workers negotiate new nominal wage contacts based on
new inflation ratio (inf(inf22)).
• Absent additional stimulus, unemployment rate returns to natural rate.
What happens in long run?What happens in long run?
Money still neutral in long run!
B
U2
Inf2
Unemployment rate
Inflation Rate
Inf1 A
The NAIRU Framework:The NAIRU Framework:In PicturesIn Pictures
Un=U1
C Result: After adjustment of inflation expectations, unemployment drifts back to the natural rate (Point C), but with a new permanently higher inflation rate (inf2).
In shortIn short::• Only repeated inflation surprises (accelerating
inflation) will keep unemployment below natural rate.
• Misguided attempts to peg unemployment rate below natural rate led to accelerating inflation and rising nominal interest rates in 1970s.
NAIRU FrameworkNAIRU Framework
Can’t fool all of the people all of the timeCan’t fool all of the people all of the time::Central banks with discretion have incentive to renege on
commitments to price stability. After public has formed expectations of inflation, central bank can
increase monetary growth to reduce unemployment.
Public will anticipate this possibility and form expectations accordingly.
Result:Result: Inflation will be higher because central bank must accommodate the expected policy (why?),(why?), but unemployment remains at natural rate.
NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle
Inf2
Unemployment Rate
Inflation Rate
Inf1 A
Un=U1
CResult: In the end, inflation will be higher but unemployment will be no lower (point C).
NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle
Policy under discretion produces results in each period Policy under discretion produces results in each period inconsistent with long-run policy goals (time-inconsistency problem).inconsistent with long-run policy goals (time-inconsistency problem).
Inf2
Unemployment rate
Inflation Rate
Inf1 A
Un=U1
C Result: Only binding rule, can make central bank’s commitment to price stability credible and keep inflation at point A.
NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle
Note result (inflationary bias) does not depend onNote result (inflationary bias) does not depend on::Imperfect knowledge
Imperfect monetary tools
Agency problems (differences in public’s and central bank’s objective functions).
NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle
Rules vs. Discretion:Rules vs. Discretion:The EvidenceThe Evidence
Rules lead to lower inflation.Rules lead to lower inflation.• U.S. on gold standard (type of rule): bundle of goods
costing $1 in 1776 cost $1.19 in 1945.• U.S. with no rule: bundle of goods costs $1.00 in March
1953 (Treasury-Fed Accord, discretionary policy) would cost $8.00 today (March 2009) .
Discretion Discretion maymay lead to greater economic stability. lead to greater economic stability.• Many economists believe U.S. business-cycle
fluctuations have been milder since World War II.
A Closer Look at Activist Rules:A Closer Look at Activist Rules:The Taylor RuleThe Taylor Rule
Fed funds rate target = Fed funds rate target = inflation rate + equilibrium real fed funds rateinflation rate + equilibrium real fed funds rate+ ½ (inflation gap) + ½ (output gap) + ½ (inflation gap) + ½ (output gap)
where:• Equilibrium real fed funds rate = neutral rate• Inflation rate = current observed rate• Inflation target = set by policy makers• Inflation gap = current inflation rate – inflation target• Output gap = percentage deviation of current real
GDP from estimate of potential GDP
A Closer Look at Activist Rules:A Closer Look at Activist Rules:The Taylor RuleThe Taylor Rule
Example:Example:• Equilibrium real fed funds rate = 2%• Inflation target = 2%• Current inflation rate = 3%• Inflation gap = current inflation (3%) – inflation target (2%)• Output gap = Current real GDP is 1% above potential.
Fed funds rate target = Fed funds rate target =
(3%) + (2%) + ½ (1%) + ½ (1%)(3%) + (2%) + ½ (1%) + ½ (1%) = 6% = 6%
Time-Inconsistency Problem Time-Inconsistency Problem Other SolutionsOther Solutions
Besides rules…Besides rules…• Reputation building• Incentive-compatible contracts for central
bankers• “Conservative” central bankers
Inflation Targeting:Inflation Targeting:A Middle Ground?A Middle Ground?
• Not really a rule; not really discretion either.• Basic features:
– Central bank announces official inflation target– Central bank explicitly acknowledges that low and stable
inflation is overriding goal of monetary policy.– Central bank becomes more transparent and more
communicative with public.– Central bank held accountable for attaining inflation
targets.
• Basic Flaw:Basic Flaw: Can you really hold central bank accountable for an inflation target?
How does the Fed set policy?How does the Fed set policy?
Taylor rule describes policy under Greenspan fairly well.Taylor rule describes policy under Greenspan fairly well.
Taylor Rule and Fed Funds Rate1960-2003
Questions over:
Advanced Topics Advanced Topics in in
Monetary Policy: Monetary Policy: Central-Bank Independence
and Rules vs. Discretion?
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