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MIT 14 02 - Conducting Monetary Policy- Overview

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BRINNER1902mit07.pptConducting Monetary Policy: Overview? The Fed’s Mandate? A Quick Review of the Effects of Monetary Policy? What are the right strategies to meet this mandate?– General Guidelines for Conducting Policy– Optimal Policy ObjectivesBRINNER2902mit07.pptThe Fed’s Mandate? Low inflation? Stabilize economic activity? Humphrey-Hawkins 1978 requires both the Fed Chair and the President to report to Congress each year on their plans for achieving both price stability and full employment– This is unusual– And arguably inadvisable!BRINNER3902mit07.pptThe Effects of Monetary Policy: Quick ReviewShort run:? Changes in money supply that “surprise” agents in the economy affect level and composition of output, via interest rate and exchange rateMedium/Long-run:? Money neutral with respect to output and unemployment (ifshort-run policy did not change capital accumulation)? Changes in the rate of money growth lead to proportional changes in the inflation rateBRINNER4902mit07.pptGeneral Guidelines: The Importance of Maintaining CredibilityConsistent vigilance against inflation is key. Example:? Say Fed has been credibly pursuing zero inflation policy, and markets therefore expect zero inflation in the future.? Since inflation = expected inflation – a(u – un) , and both inflation and expected inflation equal zero, then in equilibriumwe will have zero inflation and unemployment equal to the natural rate? But might not it be better to have even lower unemployment? (in the short-run…. make sure you can use IS-LM analyze the mechanisms through which unemployment returns to its natural rate in the medium-run).BRINNER5902mit07.pptGeneral Guidelines: Maintaining Credibility? After all, some might think it is well worth it to deviate from this equilibrium by increasing money growth 2%: then we’d have a unemployment rate that is about 2% lower (“a” is approx equal to 1) in the short-run, with only 2% inflation.? Problem: if Fed deviates from its zero inflation target to push unemployment lower, when will it stop? Markets begin to expect inflation, we end up with positive (and perhaps high) inflation in the new equilibrium.BRINNER6902mit07.pptMeeting the Mandate: What are the Right Strategies?What’s the optimal inflation rate? Two logical strategies:? Pursue zero inflation? Pursue low, positive inflation rateBRINNER7902mit07.pptIs the Optimal Inflation Rate Zero? Arguments for eliminating inflation:? Shoe-leather/Menu costs (only with hyperinflation)? Tax distortions (e.g., capital gains)? “Money illusion”; i.e., people don’t understand real v. nominal? Inflation variability—higher inflation usually associated with higher variability of inflation, which creates uncertainty? Most credible target for central bankBRINNER8902mit07.pptIs the Optimal Inflation Rate Positive? Arguments for positive (but small) rate of inflation:? Seignorage (but only with hyperinflation)– I.e., “monetizing” government debt? Option of negative real interest rates– Can provide stimulus when needed– Contrast with zero inflation regime: can’t have i<0!? Money illusion can help, if wage cuts neededBRINNER9902mit07.pptOptimal Deviations from the Chosen Inflation TargetHow far should a central bank deviate from its inflation target, temporarily, in order to stabilize the economy?The answer seems to be that it can and should go pretty far if necessary, even with stimulus, once it has established a reputation for being vigilant against inflationBRINNER10902mit07.pptOptimal Deviations from the Chosen Inflation TargetExamples of aggressive deviations, both proactive and reactive:? 7 point decrease in early 90s widely credited with reducing depth of recession? 11 rate cuts in 2001? 1.75 point decrease in months following 9/11BRINNER11902mit07.pptThe Fed in Action: Before Sept 11012345678Jan-99Feb-99Mar-99Apr-99May-99Jun-99Jul-99Sep-99Oct-99Nov-99Dec-99Jan-00Feb-00Mar-00May-00Jun-00Jul-00Aug-00Sep-00Oct-00Dec-00Jan-01Feb-01Mar-01Apr-01May-01Jun-01Aug-01Sep-012535455565758595105115Consumer Sentiment Fed Funds RateBRINNER12902mit07.pptThe Fed in Action: After Sept 11012345624-Aug-0131-Aug-017-Sep-0114-Sep-0121-Sep-0128-Sep-015-Oct-0112-Oct-0119-Oct-0126-Oct-012-Nov-019-Nov-0116-Nov-0123-Nov-0130-Nov-017-Dec-0114-Dec-0121-Dec-0128-Dec-014-Jan-0211-Jan-0218-Jan-0225-Jan-022535455565758595105115Consumer Sentiment Fed Funds


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MIT 14 02 - Conducting Monetary Policy- Overview

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