Economics 314 Coursebook, 2009 Jeffrey Parker 17 MONETARY POLICY Chapter 17 Contents A. Topics and Tools ............................................................................. 1 B. Issues in Monetary Policy ................................................................. 3 Monetary policy and inflation ....................................................................................... 3 Does monetary policy have real effects? ........................................................................... 4 Channels of transmission of monetary policy ................................................................... 5 Choosing the right targets, instruments, and operating rules ............................................. 6 Balancing short-run and long-run policy goals................................................................. 7 C. Understanding Romer’s Chapter 10 ..................................................... 8 Money and inflation ..................................................................................................... 8 Inflation and interest rates ............................................................................................. 8 Term structure of interest rates ..................................................................................... 10 Dynamic inconsistency ............................................................................................... 11 Federal-funds market .................................................................................................. 14 Optimal interest-rate rules ........................................................................................... 15 Seigniorage ................................................................................................................ 16 D. Suggestions for Further Reading ......................................................... 17 Hyperinflation and disinflation .................................................................................... 17 Money and the economy ............................................................................................. 17 Targets and instruments of monetary policy .................................................................. 18 Dynamic inconsistency of monetary policy .................................................................... 18 E. Works Cited in Text ........................................................................ 18 A. Topics and Tools Much of the material in this course has dealt with the effects of changes in the mon-ey supply on the economy. We have seen results ranging from the neutral link between money growth and inflation in the quantity theory and real-business-cycle models to the strong output effects of money in the Mundell-Fleming model under floating exchange rates. In this chapter, we put together some of the results that we have derived above and17 – 2 look in detail at some of the problems faced by the monetary authority in conducting monetary policy. The presumption in most of this analysis is that monetary policy has real effects in the short run as predicted by the IS-LM model, but is neutral in the long run. In the first sections of Romer’s Chapter 10, he reviews the basic links between mon-ey growth and inflation and between money growth and interest rates. He then carries the argument one step farther by discussing the term structure of interest rates, which is the fancy name that economists give to the relationship between short-term and long-term interest rates. In sections 10.3 and 10.4, Romer examines an important issue in monetary policy analysis: dynamic inconsistency. This problem arises when the short-run objectives of the policy authority conflict with its long-run objectives. In the case of monetary policy, there is often temptation for the central bank to increase money growth in the short run to stimulate higher output and reduce unemployment. However, the long-run result of such a change is likely to be higher inflation. It may be very difficult for even a well-intentioned central bank to convince the public that it is a serious inflation-fighter, given the expansionary temptation of short-run objectives. This may lead to higher inflationary expectations in the economy and, through the policymaker's response to this, to higher actual inflation. Section 10.5 considers a set of very basic of monetary policy issues involving the de-sirability of using countercyclical policy at all, which instruments should be used, which variables should monetary policy use as targets, and whether the monetary authority should follow a fixed rule. These are issues about which macroeconomists disagree, but they are vitally important for central banks in deciding the course of monetary policy. Sections 10.6 and 10.7 look at the literature on interest-rate rules and inflation target-ing. Because most modern central banks use some form of interest-rate target, much at-tention has focused on the optimal design of such policy rules. These sections review that literature. The final sections consider the benefits and costs of inflation. Faster expansion of the money supply can lead to greater revenue for the government through the process of seignorage. This may allow other tax rates to be lower than if a zero-inflation policy is followed. However, higher inflation also inflicts costs on the economy. The costs of un-anticipated inflation differ from those of correctly anticipated inflation. Moreover, the presence of uncertainty about inflation can sometimes inflict real costs on the economy. It is worth noting that the subject matter of this chapter is examined in detail in Eco-nomics 341: Monetary and Fiscal Policy. Students interested in a closer look at these issues are advised to consider enrolling in Econ 341.17 – 3 B. Issues in Monetary Policy There are many distinct issues involved in the study of monetary policy. Some are central issues of macroeconomics, such as studying how monetary policy affects the economy. Others are more tangential to macroeconomics and relate to the policy process itself, the structure and stability of financial markets, and the regulation and su-pervision of the banking industry. We shall direct our focus here on aspects of monetary policy that relate closely to the macroeconomic content of this course. The macroeconomic questions relating to mone-tary policy tend to fall into two major categories: