ECON330 Final Exam Study Guide Chapter 19 Two Primary Goals of Monetary Policy Price stability low stable inflation Nominal Anchor A nominal variable that policy makers use to achieve price stability such as the money supply or the inflation rate The idea is to anchor inflationary expectations Low Unemployment high stable growth Should the central bank have policy discretion regarding goals or be tied to a rule The Time Inconsistency Problem The time inconsistency problem of discretionary policy Definition A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement Destroys policymakers credibility thereby reducing effectiveness of their policies Example To reduce expected inflation the central bank announces it will tighten monetary policy and increase interest rates but faced with high unemployment the central bank may be tempted to cut interest rates To encourage investment the government announces that it will not tax income from capital but after factories have been built the government is tempted to renege on its promise to raise more tax revenue from them In general rational agents understand the incentive for the policymaker to renege and this expectation affects their behavior The solution is to take away the policymaker s discretion with a credible commitment to a fixed policy rule Linking Central Bank Tools to Objectives Central Bank Tools Open Market Operations OMO Discount Loans Reserve Req Interest on Reserves IOR IOER Policy Instruments Federal Funds Rate or Monetary base Intermediate targets Goals Objectives Linking Tools to Objectives ST and LT interest rates Monetary Aggregates M1 M2 Low Inflation growth stable interest rates Desirable Features of a Policy Instrument Easily observable by everyone Controllable and quickly changed Tightly linked to the policymakers objectives NOTE Short term interest rates are the preferred instrument of monetary policy used to stabilize short term fluctuations in prices and output Monetary Targeting Monetary Targeting the central bank announces that it will achieve a certain value the target of the annual growth rate of a monetary aggregate such as the money supply i e 5 growth in M1 United States Monetary Targeting History FED began to announce publicly its targets for money supply growth in 1975 Often failed in meeting targets Because of economic shocks Paul Vocker was more concerned with using interest rate movements to wring inflation out of the economy 1993 Greenspan states the FED would no longer use monetary aggregates to conduct monetary policy Advantages Information on whether the central bank is achieving its target is known immediately Information helps fix inflation expectations and produce less inflation Disadvantages Must be a strong and reliable relationship between the goal variable inflation or nominal income and the targeted monetary aggregate Implies that hitting the target will not produce the desired outcome on the goal variable and thus the signals on wheter they are doing so is not valid Inflation Targeting Involves several elements 1 Public announcement of targets for inflation 2 Price stability as the primary long run goal 3 Many variables are used in making decisions about monetary plicy 4 Increased transparency of the monetary policy strategy through communication with the public Examples New Zealand United Kingdom Explicit target Canada Intent Sole objective is price stability Part of central bank reform in 1990 Explicit target range Inflation was brought down and remained within the target range most of the time Governor of the central bank is accountable and can be dismissed Explicit target range Inflation brought down some costs in term of unemployment Keep inflation low which in turn anchors inflation expectations Anchor long term interest rates to promote growth i r e Follows a hierarchical mandate inflation first everything else second Remember Fed has a dual mandate Has shied away from adopting inflation targeting Inflation Targeting in Practice A framework not a rule A policy rule is inflexible requires an automatic policy response regardless of the current economic situation Purely discretionary or unconstrained policy reacts only to current developments and has no regard for long run goals Inflation targeting is meant to be constrained discretion Advantages Stability in the relationship between money and inflation is not critical to its success Doesn t rely on one variable to achieve the target Easily understood by public Monetary targets less understood Reduces the likelihood that the central bank will fall into the time inconsistency trap Reduces political pressures on the central bank to pursue inflationary monetary policy reducing time inconsistency problem Disadvantages 1 Delayed Signaling after this lag time 2 Too much rigidity a Not easily controlled by the FED b Because of long lags in monetary policy inflation outcomes only occur a Limits policymakers ability to respond to unforeseen circumstances b Target is within a range and adjustments can be made 3 Potential for Increased Output Fluctuations a Sole focus on inflation may lead to monetary policy that is too tight when inflation is above target May lead to larget output fluctuations b Possibility of deflation with low target rates 4 Low Economic Growth a However once low inflation levels are achieved output and employment return to normal Monetary Policy with an Implicit Nominal Anchor Implicit nominal anchor inflation target or a monetary aggregate target FED strategy involves an implicit anchor Presence of long labs means that monetary policy cannot wait to respond until inflation has begun To prevent inflation from getting started FED monetary policy policy needs to be forward looking and preemptive Lag is about 1 2 years Advantages Doesn t rely on a stable money inflation relationship FED uses many sources of info to determine best settings for monetary policy Forward looking behavior discourages overly expansionary monetary policy Demonstrated success Disadvantages Lack of transparency and output CHigh level of uncertainty creates doubts for public about future inflation FED cant be held responsible of no means of rating their success or failure Strong dependence on preferences skills and trustworthiness of the individuals in charge of the central bank Ex FED could face strong pressures to pursue over expansionary policy Inconsistencies with