November 20, 2012The Price Stability Goal and the Nominal AnchorOver the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policyNominal anchor: a nominal variable, such as the inflation rate or money supply, which ties down the price level to achieve price stabilityAs soon as the central bank chooses one, it gives up control of the otherFed’s dual mandate: price stability & full employmentWhenever you have expansionary monetary policy, it increases the price levelThe Fed cannot have both price stability and full employmentIf central bank purses a rigid money supply target, it is also pursuing a rigid interest rate = impossibleIf it is targeting interest rates, it has to allow the money supply to move, but it cannot choose inflation as a target for monetary policyOther Goals of Monetary PolicyFive other goals are continuously mentioned by central bank officials when they discuss the objectives of monetary policy1) High employment and output stability2) Economic growth3) Stability of financial markets4) Interest-rate stability5) Stability in foreign exchange marketsAll of these can conflict with price level stabilityShould Price Stability be the Primary Goal of Monetary Policy?Hierarchal versus Dual Mandates:Hierarchal mandates: put the goal of price stability first, and then say that as long as it is achieved other goals can be pursuedi.e. ECBDual mandates: aimed to achieved two coequal objectives: price stability and maximum employment (output stability)Price Stability as the Primary, Long-Run Goal of Monetary PolicyEither type of mandate is acceptable as long as it operates to make price stability the primary goal in the long-run, but not the short-runInflation is the #1 enemy of economic growthInflation TargetingPublic announcement of medium-term numerical target for inflationInstitutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goalInformation-inclusive approach in which many variables are use in making decisionsIncreased transparency of the strategyNo monetary policy strategy that targets price stability will work unless it is transparentTransparency allows all economic actors to plan for the future based on predicted changes in the price levelWill prevent the time-inconsistency trapNo transparency:Time inconsistency trapShort run (without transparency):Corporate profits will increaseBusinesses are buying resources at PL1, and selling at PL2Average family suffers because wages are stuck at PL1, but the general price level is now PL2Long run:SRAS falls because of increased production costsWages riseOnce change is over, the new PL does not matter  everyone is on the same page once again (E3)Only feel pain in the short runTransparency:Transparency will allow SRAS and AD to shift simultaneously (no time inconsistency = no pain)Can incorporate inflation clauses in contractsIncreased accountability of the central bankNew Zealand (effective in 1990)Inflation was brought down and remained within the target most of the timeGrowth has generally been high and unemployment has come down significantlyCanada (1991)Inflation decreased since then, some costs in term of unemploymentUnited Kingdom (1992)Inflation has been close to its targetGrowth was been strong and unemployment has been decreasingAdvantages:Does not rely on one variable to achieve targetEasily understoodReduces potential of falling in time-inconsistency trapStresses transparency and accountabilityDisadvantages:Delayed signalingToo much rigidityPotential for increased output fluctuationLow economic growth during disinflation (the rate of inflation can be decreasing, but inflation can still be increasing)Inflation Rates and Inflation Targets for New Zealand, Canada, and the UK (1980-2011)Targeting inflation has been very successfulThe Federal Reserve’s Monetary Policy StrategyThe US has achieved excellent macroeconomic performance (including low and stable inflation) until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation targetHistory:Fed began to announce publically targets for money supply growth in 1975 (before accepting inflation targeting)Paul Volker (1979) focused more on nonborrowed reserves  unsuccessful, volatile PLGreenspan announced in July 1993 that the Fed would not use monetary aggregates as a guide for conducting monetary policyBegan to target inflation (tech boom helped with real-time data)There is no explicit nominal anchor in the form of an overriding concern at the FedForward looking behavior and periodic “preemptive strikes”The goal is to prevent inflation from getting startedAdvantages:Uses many sources of informationDemonstrated successDisadvantages:Lack of accountabilityInconsistent with democratic principlesAdvantages of the Fed’s ”Just Do It” Approach:Forward-looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby diminishing the time-inconsistency problemDisadvantages of the Fed’s “Just Do It” Approach:Lack of transparency; strong dependence on the preference, skills, and trustworthiness of individuals in charge of the central bankNovember 27, 2012Lessons for Monetary Policy Strategy from the Global Financial Crisis1) Development in the financial sector (financial innovation) have far greater impacts on economic activity than was earlier realized2) The zero-lower-bound on interest rates can be a serious problemThere is only so much the central bank can do to encourage expansion3) The costs of cleaning up after a financial crisis is very high4) Price and output stability do not ensure financial stabilityThe Fed can target anything by none of those assure that financial markets are stableCan only happen based on the Fed’s visionHow should central banks respond to asset price bubbles?Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burstTypes of asset price bubbles:1) Credit-driven bubblesCaused by financial crisis, prevailing low interest ratesi.e. Housing bubble2) Irrational exuberancei.e. tech bubble  everyone wanted to join the bandwagonShould central banks respond to bubbles?Strong argument for not responding to bubbles driven by irrational exuberanceBubbles