Transcript Chpt24

Chapter 24
Strategies and
Rules
for Monetary
Policy
Introduction to Economics (Combined
Version) 5th Edition
The Search for a Strategy
 The goals of macroeconomic
policy are stability and
prosperity.
 What kind of strategy is
best?
 Would it be a strategy of fine
tuning that makes frequent
changes to policy and reacts to
every small event?
 Or a strategy of policy rules
that sets policies in advance
for greater transparency and
predictability?
Introduction to Economics (Combined
Version) 5th Edition
Fine-Tuning in the U.S. Economy
 U.S. policymakers
attempted to fine-tune the
economy in the 1960s and
1970s.
 Because of lags,
forecasting errors, and
time-inconsistency, the
result was a series of
business cycles with
increasing inflation and
unemployment.
Introduction to Economics (Combined
Version) 5th Edition
Lags
 Inside lags are delays
between the time a
problem develops and the
time a decision is taken to
do something about it.
 Examples:
 Delays in data collection
 Time needed to conduct
meetings, prepare reports,
and reach decisions
 Outside lags are delays
between the time a
decision is made and the
time actions affect the
economy.
 Examples:
 Delays in implementing a
decision
 Delays in movements along
and shifts in aggregate
supply and demand curves
Introduction to Economics (Combined
Version) 5th Edition
Inside Lag: Example
 The U.S. had a mild recession in
Jan-Nov 2001.
 May 2001 vintage data (the
data available in the middle of
the recession) did not show
start of recession, even when it
was half over.
 Fully revised data shows the
start of the recession clearly.
Introduction to Economics (Combined
Version) 5th Edition
Outside Lag: Example
 After an increase in interest
rates shifts the AD curve, real
output first falls and then
returns to the natural level
after the AS curve shifts.
 These estimates show that
the process involves a total
lag of 1 to 3 years, or longer.
 Different studies, based on
different periods and
methods, do not agree on
how long the lag is.
Introduction to Economics (Combined
Version) 5th Edition
Forecasting Errors
 To overcome the problem of lags, policymakers
must try to act in advance, based on forecasts.
 However, forecasts are not accurate. On average,
forecasts of GDP growth have an error of about
1 percent for 1 year forecasts in developed countries
2 percent for 2 year forecasts in developed countries
3 percent for 2 year forecasts in developing countries
 Forecasts are least accurate at turning points in
the business cycle, just when they are needed
most.
Introduction to Economics (Combined
Version) 5th Edition
Time-Inconsistency
 Time-inconsistency means the tendency to make
decisions that have good consequences in the
short run, but bad consequences in the long run.
 Example from everyday life: You stop taking your
medication because of bad side effects before you
are completely cured.
 Example from macroeconomics: Before an
election, policymakers use excessive expansionary
policy or avoid needed contractionary monetary
policy.
Introduction to Economics (Combined
Version) 5th Edition
Instruments, Targets, and Goals
 A policy instrument is a variable that is directly
under the control of policymakers.
 An operating target is a variable that responds
immediately, or almost immediately, to the use of
a policy instrument.
 An intermediate target is a variable that
responds to the use of a policy instrument or a
change in operating target with a significant lag.
 A policy goal is a long-run objective of economic
policy that is important for economic welfare.
Introduction to Economics (Combined
Version) 5th Edition
Monetarism
 Monetarists like Milton
Friedman advocated the use
of a steady rate of money
growth, approximately equal
to the long-run rate of growth
of real output, as an
intermediate target.
 If velocity was reasonably
stable, a money growth rule
would avoid excessive
inflation or deflation.
Equation of Exchange
MV = PQ
where
–
–
–
–
M is the money stock
V is velocity
P is the price level
Q is the rate of GDP growth
If V is constant and growth of M
equals growth of Q, P will be
constant.
Introduction to Economics (Combined
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Inflation Targeting
The rate of inflation averaged over one or two
years is the main intermediate target.
Interest rates are used as the operating
target.
Open market operations are used as the main
policy instrument.
Introduction to Economics (Combined
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Interest Rates as an Operating Target
 The Fed sets the discount rate on loans to banks and the deposit rate charged
on reserves to form a corridor.
 The federal funds target rate is set in the middle of the corridor.
 Open market operations are used to adjust the supply of reserves to keep the
federal funds rate close to its target.
Introduction to Economics (Combined
Version) 5th Edition
Adjusting the Interest Rate Target
 Inflation targeting policy sets an upper and lower limit for growth of the price
level to form a cone around the intended inflation target.
 If the actual inflation rate threatens to move outside the cone, the interest rate
target is raised to slow growth of aggregate demand.
Introduction to Economics (Combined
Version) 5th Edition
A Taylor Rule
 A Taylor Rule uses both the
inflation rate and the output
gap as intermediate targets.
 The interest rate operating
target is raised if either the
inflation rate or output gap
increases.
 The interest rate is lowered if
inflation or the output gap
decreases.
 To avoid lags in measuring the
output gap, a variation of the
Taylor rule uses employment
data.
Stanford University economist John Taylor
Introduction to Economics (Combined
Version) 5th Edition
NGDP Targeting
 NGDP targeting is a policy under
which the central bank adopts the
rate of growth of nominal GDP as
its principal intermediate target.
 NGDP targeting is more flexible
than simple monetary targeting.
 Under NGDP targeting, an
unexpected increase in velocity
could be offset by a slowdown in
the rate of growth of the money
stock, or vice versa.
During the Great Recession, NGDP
dropped far below its potential level.
Introduction to Economics (Combined
Version) 5th Edition
Appendix to Chapter 24
Demand and Supply for Money
Introduction to Economics (Combined
Version) 5th Edition
The Demand for Money
 The demand for real
money balances means
the real quantity of
money people want to
hold, other things being
equal.
 A decrease in the interest
rate decreases the
opportunity cost of
holding money and
causes a movement
along the demand curve
(A to B).
 An increase in real
income causes the money
demand curve to shift to
the right (A to C).
Introduction to Economics (Combined
Version) 5th Edition
A Change in the Interest Rate
 The supply of money is
controlled by the central
bank using open market
operations or other
instruments.
 The following could
cause an increase in the
interest rate:
 An increase in real GDP,
shifting the demand curve
 A decrease in the real
money supply while the
price level and real GDP
are constant
 An increase in the price
level while real GDP and
the nominal money
supply are constant
Introduction to Economics (Combined
Version) 5th Edition