Transcript Policy Credibility

Objectives
Distinguish among the instruments, ultimate goals, and
intermediate targets of monetary policy and review the
Fed’s performance
Describe and compare the performance of a monetarist
fixed rule and Keynesian feedback rules for monetary
policy
Explain why the outcome of monetary policy crucially
depends on the Fed’s credibility
Describe and compare the new monetarist and new
Keynesian feedback rules for monetary policy
What Can Monetary Policy Do?
In 2001, real GDP shrank and the unemployment rate
increased.
Alan Greenspan cut the interest rate to stimulate
production and jobs.
Were these actions the right ones?
Can and should monetary policy try to counter
recessions?
Or should monetary policy focus on price stability?
Instruments, Goals, Targets, and the
Fed’s Performance
To discuss monetary policy we distinguish among:
 Instruments
 Goals
 Intermediate targets
Instruments, Goals, Targets, and the
Fed’s Performance
The instruments of monetary policy are
 Open market operations
 The discount rate
 Required reserve ratios
The goals of monetary policy are the Fed’s ultimate
objectives and are
 Price level stability
 Sustainable real GDP growth close to potential GDP
Instruments, Goals, Targets, and the
Fed’s Performance
The Fed’s instruments work with an uncertain, long, and
variable time lag.
To assess its actions, the Fed watches intermediate
targets.
The possible intermediate targets are
 Monetary aggregates (M1 and M2, the monetary base)
 The federal funds rate
The Fed’s current intermediate target is the federal funds
rate.
Instruments, Goals, Targets, and the
Fed’s Performance
Price Level Stability
Unexpected swings in the inflation rate bring costs for
borrowers and lenders and employers and workers.
What Is Price Level Stability?
Alan Greenspan defined price level stability as a condition
in which the inflation rate does not feature in people’s
economic calculations.
An inflation rate between 0 and 3 percent a year is
generally seen as being consistent with price level stability.
Instruments, Goals, Targets, and the
Fed’s Performance
Sustainable Real GDP Growth
Natural resources and the willingness to save and invest
in new capital and new technologies limit sustainable
growth.
Monetary policy can contribute to potential GDP growth by
creating a climate that favors high saving and investment
rates.
Monetary policy can help to limit fluctuations around
potential GDP.
Instruments, Goals, Targets, and the
Fed’s Performance
The Fed’s Performance: 1973–2003
The Fed’s performance depends on
 Shocks to the price level
 Monetary policy actions
Instruments, Goals, Targets, and the
Fed’s Performance
Shocks to the price level during the 1970s and 1980s
made the Fed’s job harder
 World oil price hikes
 Large and increasing budget deficits
 Productivity slowdown
These shocks intensified inflation and slowed real GDP
growth.
Instruments, Goals, Targets, and the
Fed’s Performance
Shocks in the 1990s made the Fed’s job easier.
 Falling world oil prices
 Decreasing budget deficits (and eventually a budget
surplus)
 New information economy brought more rapid
productivity growth.
Instruments, Goals, Targets, and the
Fed’s Performance
Figure 16.1 summarizes monetary policy 1973-2003.
Instruments, Goals, Targets, and the
Fed’s Performance
There is a tendency for the federal funds rate to fall as an
election approaches and usually the incumbent President
or his party’s successor wins the election.
Two exceptions
 In 1980, interest rates increased, the economy slowed,
and Jimmy Carter lost his reelection bid.
 In 1992, interest rates increased, and George Bush lost
his reelection bid.
Instruments, Goals, Targets, and the
Fed’s Performance
Presidents take a keen interest in what the Fed is up to.
And as the 2004 election approached, the White House
was watching anxiously, hoping that the Fed would
continue to favor a low federal funds rate and keep the
economy expanding.
Instruments, Goals, Targets, and the
Fed’s Performance
Figure 16.2 provides a
neat way of showing how
well the Fed has done in
shooting at its target.
Achieving Price Level Stability
There are two price level problems
When the price level is stable, the problem is to prevent
inflation from breaking out.
When inflation is already present, the problem is to reduce
its rate and restore price level stability while doing the
least possible damage to real GDP growth.
Achieving Price Level Stability
The monetary policy regimes that can be used to stabilize
aggregate demand are
 Fixed-rule policies
 Feedback-rule policies
 Discretionary policies
Achieving Price Level Stability
Fixed-Rule Policies
A fixed-rule policy specifies an action to be pursued
independently of the state of the economy.
An everyday example of a fixed rule is a stop sign--“Stop
regardless of the state of the road ahead.”
A fixed-rule policy proposed by Milton Friedman is to keep
the quantity of money growing at a constant rate
regardless of the state of the economy.
Achieving Price Level Stability
Feedback-Rule Policies
A feedback-rule policy specifies how policy actions
respond to changes in the state of the economy.
A yield sign is an everyday feedback rule—“Stop if another
vehicle is attempting to use the road ahead, but otherwise,
proceed.”
A monetary policy feedback-rule is one that pushes the
interest rate ever higher in response to rising inflation and
strong real GDP growth and ever lower in response to
falling inflation and recession.
Achieving Price Level Stability
Discretionary Policies
A discretionary policy responds to the state of the
economy in a possibly unique way that uses all the
information available, including perceived lessons from
past “mistakes.”
An everyday discretionary policy occurs at an unmarked
intersection--each driver uses discretion in deciding
whether to stop and how slowly to approach.
Most macroeconomic policy actions have an element of
discretion because every situation is to some degree
unique.
Achieving Price Level Stability
Policy Lags and the Forecast Horizon
The effects of policy actions taken today are spread out
over the next two years or even more.
The Fed cannot forecast that far ahead.
The Fed can’t predict the precise timing and magnitude of
the effects of its policy actions.
A feedback policy that reacts to today’s economy might be
wrong for the economy at that uncertain future date when
the policy’s effects are felt.
Policy Credibility
A policy that is credible works much better than one that
surprises.
Contrast two cases
 A surprise inflation reduction
 A credible announced inflation reduction
Policy Credibility
A Surprise Inflation
Reduction
Figure 16.8(a) shows the
economy at full
employment on aggregate
demand curve AD0 and
short-run aggregate supply
curve SAS0.
Real GDP is $10 trillion,
and the price level is 105.
Policy Credibility
The expected inflation rate
is 10 percent.
So next year, aggregate
demand is expected to be
AD1 and the money wage
rate increases to shift the
short-run aggregate supply
curve SAS1.
Policy Credibility
If expectations are fulfilled,
the price level rises to
115.5—a 10 percent
inflation—and real GDP
remains at potential GDP.
Now suppose that the Fed
unexpectedly decides to
slow inflation.
Policy Credibility
The Fed raises the interest
rate and slows aggregate
demand growth.
The aggregate demand
curve shifts rightward to
AD2.
Real GDP decreases to
$9.5 trillion, and the price
level rises to 113.4—an
inflation rate of 8 percent a
year.
Policy Credibility
The Fed’s policy has
succeeded in slowing
inflation, but at the cost of
recession.
Real GDP is below
potential GDP, and
unemployment is above its
natural rate.
Policy Credibility
A Credible Announced Inflation Reduction
Suppose the Fed announces its intention to slow inflation
to 5 percent.
Suppose also that the Fed’s policy announcement is
credible and convincing.
The expected inflation rate becomes 5 percent a year.
Policy Credibility
In Figure 16.8(a), the SAS
curve shifts to SAS2.
Aggregate demand
increases by the amount
expected, and the
aggregate demand curve
shifts to AD2.
The price level rises to
110.25—inflation is 5
percent—and real GDP
remains at potential GDP.
Policy Credibility
In Figure 16.8(b), the lower
expected inflation rate
shifts the short-run Phillips
curve downward to
SRPC1, and inflation falls
to 5 percent a year, while
unemployment remains at
its natural rate of 6
percent.
Policy Credibility
A credible announced
inflation reduction lowers
inflation but with no
accompanying recession
or increase in
unemployment.
Policy Credibility
Inflation Reduction in Practice
When the Fed in fact slowed inflation in 1981, we paid a
high price.
The Fed’s policy action to end inflation was not credible.
Could the Fed have lowered inflation without causing
recession by telling people far enough ahead of time that it
did indeed plan to lower inflation?
The answer appears to be no.
People expect the Fed to behave in line with its record, not
with its stated intentions.
New Monetarist and New Keynesian
Feedback Rules
A monetarist rule
 Prevents cost-push inflation at the cost of recession
 Brings price level fluctuations in the face of productivity
shocks
 Brings price level and real GDP fluctuations in the face of
aggregate demand fluctuations
New Monetarist and New Keynesian
Feedback Rules
A Keynesian feedback rule that targets real GDP
 Brings cost-push inflation
 Might not moderate fluctuations in the price level and
real GDP that stem from aggregate demand shocks
A Keynesian feedback rule that targets the price level
 Prevents cost-push inflation but at an even greater cost
of recession than that of a monetarist fixed rule.
New Monetarist and New Keynesian
Feedback Rules
None of these rules work well, and none is a sufficiently
credible rule for the Fed to commit to.
In an attempt to develop a rule that is credible and that
works well, economists have explored policies that
respond to both the price level and real GDP.
Two such policy rules are the
 McCallum Rule
 Taylor Rule
New Monetarist and New Keynesian
Feedback Rules
The McCallum Rule
Suggested by Bennett T. McCallum, an economics
professor at Carnegie-Mellon University, the McCallum
rule says
Make the monetary base grow at a rate equal to the target
inflation rate plus the 10-year moving average growth rate
of real GDP minus the 4-year moving average of the
growth rate of the velocity of circulation of the monetary
base.
New Monetarist and New Keynesian
Feedback Rules
If the Fed had a specific target for the inflation rate, the
McCallum rule would tell the Fed the growth rate of
monetary base that would achieve that target, on the
average.
Figure 16.9 on the next slide shows how the monetary
base has grown and how it would have grown if it had
followed the McCallum rule.
New Monetarist and New Keynesian
Feedback Rules
New Monetarist and New Keynesian
Feedback Rules
The Taylor Rule
Suggested by John Taylor, formerly an economics
professor at Stanford University and now Undersecretary
of the Treasury for International Affairs in the Bush
administration, the Taylor rule says
Set the federal funds rate equal to the target inflation rate
plus 2.5 percent plus one half of the gap between the
actual inflation rate and the target inflation rate plus one
half of the percentage deviation of real GDP from potential
GDP.
New Monetarist and New Keynesian
Feedback Rules
Figure 16.10 shows the
federal funds rate and the
rate if the Taylor rule were
followed.
New Monetarist and New Keynesian
Feedback Rules
Differences Between the Rules
The McCallum rule and the Taylor rule tell a similar story
about the inflation of the 1970s and the price level stability
of the 1990s and 2000s.
During the 1970s, the quantity of money grew too rapidly
(McCallum rule) and the federal funds rate was too low
(Taylor rule).
New Monetarist and New Keynesian
Feedback Rules
Differences Between the Rules
During the 1990s and 2000s, both the growth rate of the
quantity of money (McCallum rule) and the federal funds
rate (Taylor rule) were consistent with low inflation and
price level stability.
But the two rules differ in two important ways
 Strength of response to output fluctuations
 Targeting money versus the interest rate
New Monetarist and New Keynesian
Feedback Rules
Choosing Between the Rules
Monetarists favor targeting the monetary base because
they believe that it provides a more solid anchor for the
price level than does the interest rate.
Keynesians say that targeting the quantity of money would
bring excessive swings in the interest rate, which in turn
would bring excessive swings in aggregate expenditure.
For this reason, Keynesians favor interest rate targeting.