Ch 16 The Conduct of Monetary Policy Strategy Tactics November 20 2012 The Price Stability Goal and the Nominal Anchor Over 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 policy Nominal anchor a nominal variable such as the inflation rate or money supply which ties down the price level to achieve price stability As soon as the central bank chooses one it gives up control of the other Fed s dual mandate price stability full employment Whenever you have expansionary monetary policy it increases the price level The Fed cannot have both price stability and full employment 1 If central bank purses a rigid money supply target it is also pursuing a rigid interest rate impossible If it is targeting interest rates it has to allow the money supply to move but it cannot choose inflation as a target for monetary policy Other Goals of Monetary Policy Five other goals are continuously mentioned by central bank officials when they discuss the objectives of monetary policy 1 High employment and output stability 2 Economic growth 3 Stability of financial markets 4 Interest rate stability 5 Stability in foreign exchange markets All of these can conflict with price level stability Should 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 pursued i e ECB Dual mandates aimed to achieved two coequal objectives price stability and maximum employment output stability Price Stability as the Primary Long Run Goal of Monetary Policy Either 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 run Inflation is the 1 enemy of economic growth Inflation Targeting Public announcement of medium term numerical target for inflation 2 Institutional commitment to price stability as the primary long run goal of monetary policy and a commitment to achieve the inflation goal Information inclusive approach in which many variables are use in making decisions Increased transparency of the strategy No monetary policy strategy that targets price stability will work unless it is transparent Transparency allows all economic actors to plan for the future based on predicted changes in the price level Will prevent the time inconsistency trap No transparency Time inconsistency trap Short run without transparency Corporate profits will increase Businesses are buying resources at PL1 and selling at PL2 Average family suffers because wages are stuck at PL1 but the general price level is now PL2 Long run SRAS falls because of increased production costs Wages rise Once change is over the new PL does not matter cid 224 everyone is on the same page once again E3 Only feel pain in the short run Transparency 3 Transparency will allow SRAS and AD to shift simultaneously no time inconsistency no pain Can incorporate inflation clauses in contracts Increased accountability of the central bank New Zealand effective in 1990 Inflation was brought down and remained within the target most of the time Growth has generally been high and unemployment has come down significantly Canada 1991 Inflation decreased since then some costs in term of unemployment United Kingdom 1992 Inflation has been close to its target Growth was been strong and unemployment has been decreasing Advantages Does not rely on one variable to achieve target Easily understood Reduces potential of falling in time inconsistency trap Stresses transparency and accountability Disadvantages Delayed signaling Too much rigidity Potential for increased output fluctuation Low economic growth during disinflation the rate of inflation can be decreasing but inflation can still be increasing 4 Inflation Rates and Inflation Targets for New Zealand Canada and the UK 1980 2011 5 Targeting inflation has been very successful The Federal Reserve s Monetary Policy Strategy The 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 target History Fed began to announce publically targets for money supply growth in 1975 before accepting inflation targeting Paul Volker 1979 focused more on nonborrowed reserves cid 224 unsuccessful volatile PL Greenspan announced in July 1993 that the Fed would not use monetary aggregates as a guide for conducting monetary policy Began 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 Fed Forward looking behavior and periodic preemptive strikes The goal is to prevent inflation from getting started Advantages Uses many sources of information Demonstrated success Disadvantages Lack of accountability Inconsistent with democratic principles Advantages 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 problem Disadvantages 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 bank 6 November 27 2012 Lessons for Monetary Policy Strategy from the Global Financial Crisis 1 Development in the financial sector financial innovation have far greater impacts on economic activity than was earlier realized 2 The zero lower bound on interest rates can be a serious problem There is only so much the central bank can do to encourage expansion 3 The costs of cleaning up after a financial crisis is very high 4 Price and output stability do not ensure financial stability The Fed can target anything by none of those assure that financial markets are stable Can only happen based on the Fed s vision How should central banks respond to asset price bubbles Asset price bubble pronounced increase in asset prices that depart from fundamental values which eventually burst Types of asset price bubbles 1 Credit driven bubbles Caused by financial crisis prevailing low interest rates i e Housing bubble 2 Irrational exuberance i e tech bubble cid 224 everyone wanted to join the bandwagon Should central banks respond to bubbles Strong argument for not