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NYU ECON1-UC 6607 - Monetary Policy

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Global EconomyChris EdmondMonetary PolicyRevised: January 9, 2008In most countries, central banks manage interest rates in an attempt to produce stable and pre-dictable prices. In some countries they are also asked to moderate fluctuations in output andemployment. We discuss these roles and summarize actual policy in terms of the popular ‘Taylorrule’.Roles of monetary policyIt’s hard to talk about what central banks should do before considering what they’re capable ofdoing. There is clear evidence that they can control the price level and inflation, at least overperiods of a year or more. There is also clear evidence that countries with high and variableinflation rates have poor macroeconomic performance, although the cause and effect are less clear.With these facts in mind, most countries charge their central banks with producing stable andpredictable prices. In practice, this is typically understood to mean a stable inflation rate of 2-3%a year.In the US, the Federal Reserve Act asks the Fed ‘to promote the goals of maximum employment,stable prices, and moderate long-term interest rates’. The term maximum employment is inter-preted to mean that the Fed should act to reduce the magnitude and duration of fluctuationsin output and employment. What role does monetary policy play in these fluctuations? Expertopinion is currently that monetary policy has, at best, a modest impact. Certainly, the long-termgrowth rate of the economy does not depend on a country’s monetary policy, but rather on itsinstitutions and productivity. In the short run, expansionary monetary policy (low interest rates,high money growth) probably has a modest positive effect on employment and output, but theeffect is almost certainly small. Worse, too much monetary expansion seems to lead not to higheroutput but to high inflation and lower output. Most experts suggest, therefore, that central banks(including the Fed) should emphasize price stability and give secondary importance to output andemployment.Fed Chair Ben Bernanke puts it this way:The early 1960s [were] a period of what now appears to have been substantial over-optimism about the ability of [monetary] policymakers to ‘fine-tune’ the economy. Con-trary to the expectation of that era’s economists and policymakers, the subsequent twoMonetary Policy 2decades were characterized not by an efficiently managed, smoothly running economicmachine but by high and variable inflation and an unstable real economy, culminatingin the deep 1981-82 recession. Although a number of factors contributed to the pooreconomic performance of this period, I think most economists would agree that the de-ficiencies of ... monetary policy — including over-optimism about the ability of policyto fine-tune the economy ... and insufficient appreciation of the costs of high inflation— played a central role.PredictabilityAnother hard-earned lesson of monetary policy is that it’s important to be predictable. Firmsand workers need to know what inflation is likely to be when they agree to wages. Investors andissuers of bonds need to know inflation to judge interest rates. Uncertainty about future policymakes it more difficult to judge future inflation in a world in which many prices are set in nominalterms. As Bernanke suggested, the unpredictability of policy in the 1970s was a factor in the poormacroeconomic performance of that decade.With this lesson in mind, most central banks adopted procedures over the last two decades thatmake policy more predictable. Several countries followed money growth rate rules, in which thetarget growth rate of the money supply was announced in advance. Many developing countriesadopted fixed exchange rates against the dollar or euro, with the intention of making the value oftheir currencies predictable in terms of a more stable currency. The difficulty here is that fixedexchange rate systems sometimes collapse, making the currencies less predictable. Various meanshave been used to make exchange rate regimes more durable, with mixed success. The logic in allof these examples is that predictability of future policy allows firms and individuals to understandthe impact of their economic decisions.Taylor’s ruleStanford economist John Taylor suggested in 1993 an interest rate rule would provide a relativelysimple summary of good monetary policy as practiced in developed countries at that time — andnow. The rule consists of the following equation:it=r + πt+ a1(πt− π) + a2(yt− yt), (1)where itis the short-term nominal interest rate, r is a target real interest rate, πtis the continuously-compounded inflation rate, π is the target inflation rate, and yt− ytis the deviation of log realGDP (yt) from its trend (yt). The parameters (a1, a2) indicate the sensitivity of the interest rateMonetary Policy 3to inflation and output and thus capture the two goals of monetary policy: stable prices and(possibly) reduced cyclical variation in output.This is a lot to swallow the first time you see it, so let’s work our way though piece by piece asthis is applied to US monetary policy.• Nominal interest rate it. Standard practice is to use the ‘fed funds rate’. In the US, com-mercial banks and other ‘depository institutions’ have accounts (deposits) at the FederalReserve that are referred to as fed funds. They trade these deposits among themselves inan overnight fed funds market. The Fed currently indicates its policy stance by setting anexplicit target for the interest rate on these trades. For practical purposes, this rate is thevery short end of the yield curve.• Target real interest rate r. Experience suggests that the real fed funds rate (nominal rateminus inflation) has averaged about 2% over the last two decades, but it might very wellmove around over time, both over long periods of time (the 1980s had unusually high realinterest rates) and over the business cycle. For practical purposes, we set r = 0.02 and use itas an anchor on the level of the fed funds rate. The first component of the target fed fundsrate is thus the target real rate (2%) plus the current inflation rate, thus giving us a nominalinterest rate.• Inflation deviation (πt− π). The next term is a reaction to the difference between currentinflation and the target. If the target is 2% and actual inflation is 3%, then we increase thenominal fed funds rate by a1. Typically a1> 0, meaning that we increase the interest ratein response to above-target


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