unit 3: monetary policy monetary policy targets 4/5/2011
DESCRIPTION
open market operations discount rate required reserve ratio Monetary Policy ToolsTRANSCRIPT
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