Transcript 17 - Holy Family University

Chapter 17: Monetary Policy Targets and Goals
Chapter Objectives
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Explain why the Fed was generally so ineffective before the late 1980s.
Explain why macroeconomic volatility declined from the late 1980s until
2008.
List the trade-offs that central banks face and describe how they confront
them.
Define monetary targeting and explain why it succeeded in some countries
and failed in others.
Define inflation targeting and explain its importance.
Provide and use the Taylor Rule and explain its importance.
2. Central Bank Goal Trade-offs
Primary objective of Central banks
Maximize price
stability
Minimize
unemployment
2. Central Bank Goal Tradeoffs
Unemployment
Frictional
Structural
is a little unemployment; allows the labor
market to function smoothly
when workers’ skills do not match job
requirements; inevitable in a dynamic
economy
As structural unemployment increased in the United
States, education improved somewhat
Fed shoots for natural rate of unemployment—could be 5
percent, give or take
3. Central Bank Targets
Goal
Maximize price stability
Minimize unemployment
• Hold the line (no ∆)
• Tighten (increase i, decrease or slow the growth of MS)
• Ease (lower i, increase MS)
Tools
• Open market operations
• Discount rate
• Reserve requirement
3. Central Bank Targets
Target: Aggregate MS (M1 or M2)
Problems
• Time inconsistency
• Time lags between policy implementation and realworld effects
• Difficulty predicting the importance of specific
aggregates as a determinant of interest rates and the
price level
• Disjoint between tools and targets
3. Central Bank Targets
Target: Inflation
• Frees central banks to do whatever it takes to
keep prices in check
• Forces central banks to use all available
information and not just monetary statistics
• Makes central banks more accountable
– success or failure is easily monitored
4. The Taylor Rule
“What is a monetary policy rule? At its most basic level,
it is a contingency plan that lays out how monetary
policy decisions are, or should be, made. Let me start
with the example of the Taylor rule... Originally the rule
was meant to be normative: a recommendation of what
the Fed should do. It was derived from monetary
theory, or more precisely from optimization exercises
using new dynamic stochastic monetary models with
rational expectations and price rigidities.”
-- John Taylor, the Adam Smith Lecture, Annual Meeting of the
National Association of Business Economics September 10, 2007
4. The Taylor Rule
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The Taylor Rule
fft = π + ff*r + ½(π gap) + ½(Y gap)
fft = federal funds target
π = inflation
ff*r = the real equilibrium fed funds rate
π gap = inflation gap (π – π target)
Y gap = output gap (actual output [e.g. GDP] - output
potential)
4. The Taylor Rule
The Taylor Rule
fft = π + ff*r + ½(π gap) + ½(Y gap)
If π gap > 0, then π > π target, then fft > ff*r
Or, if inflation is greater than target inflation, the target
fed funds rate should be raised.
If π gap < 0, then π < π target, then fft < ff*r
Or, if inflation is less than target inflation, the target Fed
Funds rate should be lowered.
4. The Taylor Rule
The Taylor Rule
fft = π + ff*r + ½(π gap) + ½(Y gap)
Is counter-cyclical:
If inflation or output indicates overheating, the target
fed funds rate should be raised to slow growth.
Or
If deflation or excess capacity indicates sluggishness,
the target fed funds rate should be lowered to
stimulate growth.
4. The Taylor Rule
The Taylor Rule
fft = π + ff*r + ½(π gap) + ½(Y gap)
is counter-cyclical
and accounts for two important Federal Reserve goals:
price stability and employment/output.
Since 1960, when the fft and the Taylor Rule were
closely matched, the economy has had low inflation
and strong growth.