Chapter 19 The Condict of Monetary Policy Strategy Tactics I Monetary Targeting is reasonable for hitting target annual growth rate of a monetary aggregate The central Bank a Not a reliable guide for targeting moneytary growth b Most Countries abondended philosophy c Advantages i Public can know if bank is hitting target almost immediately ii d Disadvantages i Immediate accountability to keep inflation low If relationship between monetary aggregate and the goal viable is weak monetary aggregate targeting will not work II Inflation Targeting a Elements i Public announcement of mediumterm numerical objects targets for inflation ii An institutional commitment to price stability as the primary long term goal of monetary policy and a commitment to achieve the inflation goal iii An information inclusinve approach in which many variables are iv v used in making decisions about monetary policy Increased transparency of the monetary policy strategy through communication with public about plans and objectives Increased accountability of the central banks for attaining its inflation objectives i Stability in the relationship of money and inflation is not critical ii Use all info to determine the best monetary policy iii Readily understood by the public iv Highly transparent v vi Reduce political pressure on the banks in order to keep Increased accountability of central banks b Advantages unemployment low c Disadvantages i Delayed Signaling 1 inflation has a lag ii Too Much Rigidity 1 limits ability to respond to unforeseen circumstances iii Potential for Increased Output Fluctuations 1 monetary policy that is too tight when inflation is above levels and lead to large output fluctuations iv Low economic Growth 1 low growth if output and employment III Monetary Policy with an Implicit Nominal Anchor a Monetary policy effects have long lags b Just Do It Approach i Advantages 1 same advantages of inflaton targeting 2 does not rely on stable money inflation relationships ii Disadvantages 1 lack of transparency a unnecessary colatility in financial markets 2 hard to hold Fed accountable 3 strong dependence of people running the Fed IV Choosing the Policy Instrumenet is a variable that responds to the central banks tools and indicates the stance of monetary policy a Reserve Aggregates i Reserves ii Nonborrowed reserves iii Monetary base iv Nonborrowed base b Interst Rate i Short term 1 Federal Funds Rate c Criteria for Shoosing Policy Instrument i Observable and Measuable 1 ii Controllable interst rates are more observable and measurable 1 have effective control over a variable iii Predictable Effects on Goals 1 must have a predictive effect on a goal 2 most banks use short trerm interest rates V The Taylor Rule federal funds rate should be set equal to the inflation rate plus an equilibrium real fed funds rate plus a weighted average of two gaps inflation gap current inflation minus target and an output gap percentage division of real GDP from an estimate of its potential full employment level a Federal Funds Rate Target inflation rate eq real federal funds rate i Equilibrim Federal Funsd Rate 5 inflation gap 5 output gap b Rise of inflation by 1 leads to a rise in Fedral funds rate of 5 VI Central Banks response to Asset Price Bubbles a Two types of asset price bubbles i Credit Driven Bubble 1 easy credit can be used to purchase particular assets which 2 3 inturn can lead to higher prices this increase in prices of assets can increase banks assets ewhich can enable it to lend more money this increase in price of assets can cause investors to have more collateral to take out bigger loans ii Bubbles driven by irrational exuberance 1 far less dangerous because it does not cause people to go bankrupt b Should central banks respond to bubbles i No because it is almost immpossibe to identify bubbles before they burst If one could there would be no bubble c Should Monetary Policy try to prick asset priced bubbles i No VII Fed Policy Procedures Historical Perspective a Early Earls Discount Policy as the the Primary Toll i Used discount rate to stop inflation b Discovery of open Market Oerations i Accidentily discovered this c The Great Depression i Did not act as a lender of last resort and 1 3 of banks failed d Reserve Requirment as a Policy Tool i Could now alter reserve requirments without presidents approval e War Financing and Pegging the Interest Rate i Fed would purchase bonds to drive prices up and keep YTTM down to make fiancing the war cheap f Targeting Money Market Conditions i As National Income Rose lead to rise in market interest rate then the fed would purchase bonds to bid prices up and lower interest reates monetary base would rise money supply would rise