Transcript Chapter 18 - Pearson Canada

chapter 18
Conduct of Monetary Policy:
Goals and Targets
Goals of Monetary Policy
Goals
1. High Employment
2. Economic Growth
3. Price Stability
4. Interest Rate Stability
5. Financial Market Stability
6. Foreign Exchange Market Stability
Goals often in conflict
Copyright © 2002 Pearson Education Canada Inc.
18- 2
High Employment
High employment is a worthy goal for two reasons:
1. The alternative situation, high unemployment, causes much
human misery, with people suffering financial distress, loss of
personal self-respect, and  in crime.
2. When u is high, the economy has not only idle workers but also
idle resources, resulting in a lower GDP.
But how low should u be? Because frictional unemployment (which
involves searches by workers and firms to find suitable
matchups) is desirable, and because policy can do little about
structural unemployment (due to a mismatch between job
requirements and the skills of workers), the goal of high
employment should seek not u = 0 but u > 0 consistent with full
employment (at which the demand for labor equals the supply of
labor). This level of u is called the natural rate of
unemployment.
Copyright © 2002 Pearson Education Canada Inc.
18- 3
Economic Growth
The goal of steady economic growth is closely related to the
goal of low u, because businesses are more likely to invest in
physical capital to  productivity and growth when u is low.
If u is high and factories are idle, it does not pay for firms to
invest in additional physical capital.
Hence, policies can be specifically aimed at promoting
economic growth by directly encouraging firms to invest or by
encouraging people to save, which provides more funds for
firms to invest. In fact, this is the stated purpose of so-called
supply-side economic policies, which provide tax incentives for
firms to invest more and for people to save more.
Copyright © 2002 Pearson Education Canada Inc.
18- 4
Price Stability
In recent years, policymakers have become increasingly aware
of the social and economic costs of inflation and more
concerned with a stable P as a goal of economic policy.
In fact, P stability is viewed as the most important goal for
monetary policy because
1. inflation creates uncertainty that may hamper growth
2. inflation makes it hard to plan for the future
3. inflation may strain a country’s social fabric (by creating
conflicts between different groups)
4. extreme inflation, known as hyperinflation, leads to slower
growth, as for example in Argentina, Brazil, and Russia in
the recent past.
Copyright © 2002 Pearson Education Canada Inc.
18- 5
Interest-Rate Stability
Interest-rate stability is desirable because fluctuations in
interest rates can create uncertainty and make it harder (for
both firms and households) to plan for the future.
A central bank may also want to reduce upward movements
in interest rates because such movements generate hostility
toward central banks and lead to demands that their
independence and power should be reduced (see Chapter
14).
Copyright © 2002 Pearson Education Canada Inc.
18- 6
Stability of Financial Markets
Financial crises can interfere with the ability of financial
markets to channel funds from surplus spending units to
deficit spending units, thereby leading to a sharp
contraction in economic activity.
The promotion of a more stable financial system in which
financial crises are avoided is thus an important goal for a
central bank.
The stability of financial markets is also fostered by i
stability because fluctuations in i create uncertainty for
financial firms, affecting both their profits as well as their
net worth.
Copyright © 2002 Pearson Education Canada Inc.
18- 7
Stability in Foreign Exchange
Markets
E 
euro
$
The value of the $ has become a major consideration for
the Bank of Canada. An  in E makes Canadian industries
less competitive with those abroad and a  in E stimulates
inflation in Canada.
Also, preventing large changes in E makes it easier for
firms and people involved in international trade to plan
ahead.
Stabilizing extreme movements in E in FX markets is thus
viewed as a worthy goal of monetary policy. In fact, in
countries that are even more dependent on foreign trade,
stability in FX markets takes on even greater importance.
Copyright © 2002 Pearson Education Canada Inc.
18- 8
Conflict Among Goals
Many of the goals mentioned are consistent with each other
as, for example,
• high employment with economic growth, and
• i stability with financial market stability.
However, P stability is in conflict with i stability and low u
in the short run (but probably not in the long run). For
example, when the economy is expanding and u  both 
and i may start to . If the Bank tries to prevent an  in i,
this may cause the economy to overheat and stimulate .
But if the Bank  i to prevent , in the short run u may .
The conflict among goals may thus present central banks
with some hard choices!
Copyright © 2002 Pearson Education Canada Inc.
18- 9
Central Bank Strategy
Notice that there are two different
types of target variables: interest
rates and aggregates (monetary
aggregates and reserves aggregates).
Copyright © 2002 Pearson Education Canada Inc.
18- 10
Use of (Operating and
Intermediate) Targets
Suppose that the Bank wants to achieve a 5% rate of
growth for nominal GDP and is targeting an aggregate (say
M1+). If the Bank feels that the 5% nominal GDP growth
rate will be achieved by a 4% growth rate for M1+ (its
intermediate target), which will in turn be achieved by a
3% MB growth rate (its operating target), it will use its
tools to achieve the 3% MB growth rate.
After implementing this policy, if the Bank finds that MB is
growing too slowly, it can use open market purchases to
increase it. Somewhat later the Bank will begin to see how
its policy affects the growth rate of M1+. If M1+ is
growing too fast (say at 7%), the Bank will reduce its open
market purchases or make open market sales to reduce the
M1+ growth rate.
Copyright © 2002 Pearson Education Canada Inc.
18- 11
Money Supply Target
Hence, a monetary
aggregate target
involves losing
control of i.
1. M d fluctuates
between M d' and M d''
2. With M-target at M*, i
fluctuates between i'
and i''
Figure 18-2
Copyright © 2002 Pearson Education Canada Inc.
18- 12
Interest Rate Target
1. M d fluctuates
between M d'
and M d''
2. To set i-target at
i* Ms fluctuates
between M' and
M''
Hence, an i target
involves losing
control of
aggregates
(monetary
aggregates and
reserves
aggregates).
Figure 18-3
Copyright © 2002 Pearson Education Canada Inc.
18- 13
Choosing Targets
The conclusion from Figures 18-2 and 18-3 is that interest rate
and monetary aggregate targets are incompatible: a central
bank can hit one or the other but not both.
Because a choice between them has to be made, we need to
examine what criteria should be used to decide on the target
variable.
Copyright © 2002 Pearson Education Canada Inc.
18- 14
Criteria for Choosing Targets
Criteria for Intermediate Targets
1. Measurability
2. Controllability
3. Ability to Predictably Affect Goals
Interest rates aren’t clearly better than M s on criteria 1 and 2
because hard to measure and control real interest rates
Criteria for Operating Targets
Same criteria as above
Reserve aggregates and interest rates about equal on criteria 1 and
2. For 3, if intermediate target is M s, then reserve aggregate is
better
Copyright © 2002 Pearson Education Canada Inc.
18- 15
History of Bank of Canada
Policy Procedures
Early Years: Interest Rate Targeting
1. 1962-1971, Fixed exchange rate (Bretton Woods System)
2. 1971-1975, Flexible exchange rate
Result: During the early years, i or (i - i*) were the
intermediate target of Canadian monetary policy and the
Bank’s objective was to keep the FX market and domestic
bond markets functioning smoothly. The Bank paid no
attention to the growth rate of M. As a result, monetary
policy was expansionary, and by 1974   to double digits
(to 11%) compared to only 3% in 1971.
Copyright © 2002 Pearson Education Canada Inc.
18- 16
Inflation Rates
During the early years, i or (i - i*) were the
intermediate target of Canadian monetary
policy. As a result, i and  followed
generally similar patterns in Canada and the
U.S.
Interest Rates
Copyright © 2002 Pearson Education Canada Inc.
18- 17
Targeting Monetary Aggregates:
1975-81
By the end of 1975 there was a consensus among central banks
that fluctuations in M contained useful information about P and Y.
This evidence contributed to the rise of monetarism (a theory that
emphasized a steady, predictable ). In response to this and the
rising  in the early 1970’s:
1. the Bank introduced a program of “monetary gradualism,” under
which M1 growth would be controlled within a gradually falling
target range (see Table 18-1)
2. the Bank, however, continued to use an interest rate as its
operating target
Result: Bank was successful at keeping actual M1 growth within the
target range (see Table 18-1), but   because of a series of
financial innovations that  the demand for M1 and  the demand
for M2. Monetary targeting was abandoned in November 1982.
Copyright © 2002 Pearson Education Canada Inc.
18- 18
The Bank was to announce in advance (in order to influence
people’s  expectations) the target path for the growth of M1
and then adjust policy during the course of the year to make
the actual growth rate lie within the target range.
Copyright © 2002 Pearson Education Canada Inc.
18- 19
The Checklist Approach:
1982-88
1.
With the abandonment of M1 targets, the Bank focused on a
list of factors, including i, E, and broad monetary aggregates
(like M2 and M2+), but no aggregate was found suitable as a
guide for conducting monetary policy
2. The goal of monetary policy was  containment in the short
term and price stability in the long term
3. i was the operating target and E was the intermediate target
(with the Bank resisting  in E, fearing that depreciation
would worsen )
Result:   again (because of a persistent federal budget deficit
that made it difficult for the Bank to control M and ). The
Bank responded by announcing early in 1988 that short-term
issues would henceforth less guide policy and that P stability
would be the Bank’s long-term objective of monetary policy
Copyright © 2002 Pearson Education Canada Inc.
18- 20
Inflation Targeting:
1989-Present
•
2.
3.
4.
5.
In February 1991, the Bank and the minister of finance
“jointly” announced explicit targets for , with a band of ±1%
around them.
The targets were 3% by the end of 1992, falling to 2% by the
end of 1995, to remain within a range of 1 to 3% thereafter.
The 1% to 3% target range for  was renewed in 1995, in early
1998, and again in May 2001, to apply until the end of 2006.
The midpoint of the current  target range, 2%, is regarded as
the most desirable outcome.
In setting its  targets, the Bank uses inflation in “core CPI”
which excludes volatile components (such as food, energy, and
the effect of indirect taxes).
Defining the  targets in terms of ranges gives the Bank
sufficient flexibility to deal with supply shocks.
Copyright © 2002 Pearson Education Canada Inc.
18- 21
Inflation Rate and Inflation Targets
for Canada, 1980-2000
Copyright © 2002 Pearson Education Canada Inc.
18- 22
International Considerations
Globalization (the growing integration and interdependence of
national economies) has also affected Bank of Canada
policymaking in recent years.
Globalization requires international policy cooperation, to
improve the functioning of international financial markets and
the efficiency of domestic monetary policy.
International cooperation has been encouraged by the process of
international policy coordination (agreements among
countries to enact policies cooperatively) that led to the Plaza
Agreement in 1985 and the Louvre Accord in 1987.
Copyright © 2002 Pearson Education Canada Inc.
18- 23
The Plaza Agreement and
the Louvre Accord
The Plaza Agreement was reached at New York’s Plaza Hotel in
September of 1985 between finance ministers and the heads of
central banks from the Group of Five (G-5) — the U.S., the
U.K., France, West Germany, and Japan. It was agreed to bring
down the value of the U.S. $ to address U.S. concerns that the
strong U.S. $ was reducing the competitiveness of American
corporations.
By 1987 the U.S. $ had indeed  by about 35% relative to other
currencies. At this point to address concerns over the significant
 in the U.S. $, policymakers from the G-5 plus Canada met in
February 1987 at the Louvre Museum in Paris and agreed to
stabilize exchange rates around the then prevailing levels.
Copyright © 2002 Pearson Education Canada Inc.
18- 24
Inflation Targeting
Five Elements
1. Public announcement of medium-term -target
2. Institutional commitment to price stability
3. Information inclusive strategy
4. Increased transparency through public communication
5. Increased accountability
Copyright © 2002 Pearson Education Canada Inc.
18- 25
Advantages of Inflation Targeting
1. Allows focus on domestic considerations and enables monetary
policy to respond to shocks to the domestic economy
2. Not dependent on reliable relationship between M and 
3. Readily understood by the public
4. Reduce political pressures for time-inconsistent policymaking
5. Puts great stress on making policy transparent and on regular
communication with the public
6. Increased accountability of central bank (that can be
instrumental in building public support for the central bank’s
independence
7. Performance good:  and  e  , and stays low in business cycle
upturn
Copyright © 2002 Pearson Education Canada Inc.
18- 26
Disadvantages of Inflation
Targeting
1. Delayed signalling
2. Too much rigidity
3. Potential for increased output fluctuations
4. Low economic growth
Copyright © 2002 Pearson Education Canada Inc.
18- 27
… Delayed Signalling
Given that the Bank cannot easily control  and also the “long
and variable lags” in the effects of policy,  outcomes are
revealed only after a lag. Thus, an  target sends delayed
signals to the markets about the stance of monetary policy.
However, the signals provided by other strategies (i.e., Mtargeting and E-targeting) are not very strong either.
Hence, a case can be made that other strategies are not superior
to inflation targeting on these grounds.
Copyright © 2002 Pearson Education Canada Inc.
18- 28
… Too Much Rigidity
It has been argued that -targeting imposes a rigid rule on
monetary policymakers, limiting their discretion to respond to
unforseen shocks.
Although there are advantages from “rule like” policymaking,
-targeting as practised by the Bank of Canada is far from
rigid.
The Bank does not follow simple and mechanical policy rules
in conducting monetary policy. In fact, it uses all available
information on a number of variables to determine what policy
actions are appropriate to achieve the inflation target.
Copyright © 2002 Pearson Education Canada Inc.
18- 29
… Increased Output Fluctuations
It has been argued that -targeting may lead to tight policy
when  > * and thus may lead to larger Y fluctuations.
But -targeting does not require a sole focus on . The decision
of central banks to choose  targets above zero reflects the
concern that zero  may have negative effects on the economy.
For example, deflation is fearful (because it may promote
financial instability) and targeting  > 0 makes period of
deflation less likely. This is why, * = 2%.
Moreover, -targeting does not ignore traditional stabilization
goals. The Bank of Canada and all -targeting central banks
continue to express their concern about fluctuations in Y and u.
Also, they have been willing to minimize Y declines by
gradually lowering medium-term  targets toward the long-run
goal.
Copyright © 2002 Pearson Education Canada Inc.
18- 30
… Low Economic Growth
It has also been argued that -targeting may lead to low growth
in Y.
Although  reduction has been associated with below-normal Y
during the disinflationary phases, once low  has been
achieved, Y and employment return to levels as high as they
were before.
Hence, once low  is achieved, -targeting is not harmful to the
economy, but promotes real economic growth.
Copyright © 2002 Pearson Education Canada Inc.
18- 31
The Taylor Rule
How is the target ior chosen?
Overnight rate = inflation
+ equilibrium real overnight rate
+ 1/2 (inflation gap)
+ 1/2 (output gap)
The presence of both an inflation gap and an output gap in
the Taylor rule indicates that the Bank cares not only
about keeping  low but also about minimizing business
cycle fluctuations of y around its potential. This is
consistent with many statements of Bank officials that
controlling  and stabilizing y are important concerns of
the Bank.
Copyright © 2002 Pearson Education Canada Inc.
18- 32
An Example of the Taylor Rule
Suppose that the equilibrium real overnight rate is 2%,
that * = 2% and  = 3%, leading to a positive inflation
gap of  - * = 1% (= 3% - 2%). Also assume that real
GDP is 1% above its potential, resulting in a positive
output gap of 1%.
Then the Taylor rule suggests that the overnight rate
should be set at
ior = 3% + 2% + ½ (1% inflation gap)
+1/2 (1% output gap) = 6%.
Copyright © 2002 Pearson Education Canada Inc.
18- 33
Taylor Rule, NAIRU, and
the Phillips Curve
An alternative interpretation of the presence of the output gap in the
Taylor rule is that the output gap is an indicator of future , as stipulated
in Phillips curve theory. This theory indicates that changes in  are
influenced by the state of the economy relative to its productive capacity,
measured by potential GDP which is a function of the natural rate of
unemployment. A related concept is the NAIRU, the nonaccelerating
inflation rate of unemployment (the u at which  = 0).
When u > NAIRU, with GDP < potential GDP,  will 
When u < NAIRU, with GDP > potential GDP,  will 
Prior to 1995, NAIRU was thought to be 8%, but the  in u in the late
1990s, with no  in , has rendered Phillips curve theory highly
controversial.
Copyright © 2002 Pearson Education Canada Inc.
18- 34
Taylor Rule and Overnight Rate
Copyright © 2002 Pearson Education Canada Inc.
18- 35