Chapter 16 What Should Central Banks Do? Monetary

Chapter 16 What Should Central Banks Do? Monetary

Chapter 16 What Should Central Banks Do? Monetary Policy Goals, Strategy, and Tactics The Price Stability Goal Low and stable inflation Inflation

Creates uncertainty and difficulty in planning for future Lowers economic growth Strains social fabric Nominal anchor Time-inconsistency problem Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-2

Other Goals of Monetary Policy High employment Economic growth Stability of financial markets Interest-rate stability Foreign exchange market stability Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-3 Should Price Stability be the Primary Goal?

In the long run there is no conflict between the goals In the short run it can conflict with the goals of high employment and interest-rate stability Hierarchical mandate Dual mandate Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-4 Monetary Targeting Flexible, transparent, accountable

Advantages Almost immediate signals help fix inflation expectations and produce less inflation Almost immediate accountability Disadvantages

Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-5 Inflation Targeting I Public announcement of medium-term numerical target for inflation Institutional commitment to price stability as the primary, long-run goal of monetary policy

and a commitment to achieve the inflation goal Information-inclusive approach in which many variables are used in making decisions Increased transparency of the strategy Increased accountability of the central bank Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-6 Inflation Targeting II Advantages

Does not rely on one variable to achieve target Easily understood Reduces potential of falling in time-inconsistency trap Stresses transparency and accountability Disadvantages

Delayed signaling Too much rigidity Potential for increased output fluctuations Low economic growth during disinflation Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-7 Copyright 2007 Pearson Addison-Wesley. All rights reserved.

16-8 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-9 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-10 Implicit Nominal Anchor Forward looking and preemptive

Advantages Uses many sources of information Avoids time-inconsistency problem Demonstrated success Disadvantages

Lack of transparency and accountability Strong dependence on the preferences, skills, and trustworthiness of individuals in charge Inconsistent with democratic principles Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-11 Copyright 2007 Pearson Addison-Wesley. All rights reserved.

16-12 Tactics: Choosing the Policy Instrument Tools Open market operation Reserve requirements Discount rate

Policy instrument (operating instrument) Reserve aggregates Interest rates May be linked to an intermediate target Interest-rate and aggregate targets are incompatible Copyright 2007 Pearson Addison-Wesley. All rights reserved.

16-13 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-14 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-15 Criteria for Choosing the Policy Instrument Observability and Measurability

Controllability Predictable effect on Goals Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-16 The Taylor Rule, NAIRU, and the Phillips Curve Federal funds rate target = inflation rate + equilibrium realfed fundsrate +1/2 (inflation gap)+1/2 (output gap) An inflation gap and an output gap

Stabilizing real output is an important concern Output gap is an indicator of future inflation as shown by Phillips curve NAIRU Rate of unemployment at which there is no tendency for

inflation to change Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-17 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 16-18

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