1. Macroeconomic Policy Junhui Qian Intermediate Macroeconomics

2. Content • Monetary Policy • Received Principles • Science of Monetary Policy • Art of Monetary Policy Intermediate Macroeconomics

3. Received Principles of Monetary Policy • Inflation is always and everywhere a monetary phenomenon; • Price stability has important benefits; • There is no long-run trade-off between unemployment and inflation; • Expectations play a crucial role in the determination of inflation and in the transmission of monetary policy to the macro economy; • Real interest rates need to rise with higher inflation, i.e., the Taylor Principle; • Monetary policy is subject to the time inconsistency problem; • Central bank independence helps improve the efficiency of monetary policy; • Commitment to a strong nominal anchor is central to producing good monetary policy outcomes; • Financial frictions play an important role in business cycles. Intermediate Macroeconomics

4. Generations of Macroeconomic Models Used in Policy Analysis • Early Keynesian econometric models (Tinbergen 1939, Klein 1968): no important role for monetary policy. • The MIT-Penn-SSRC (MPS) model (Modegliani et al., 1960s): important role for monetary policy. • In the 1970s, the accelerationist Phillips curve was incorporated in MPS. • The FRB/US model (Brayton and Tinsley 1995; Reifschneider, Stockton and Wilcox 1997; Reifschneider, Tetlow, and Williams 1999): important role for expectation. • DSGE with New-Keynesian features (Woodford 2003) Intermediate Macroeconomics

5. The Trend Toward Central Bank Independence • Before 1990s, only a few central banks were highly independent: the Bundesbank, the Swiss National Bank, the Federal Reserve. • In the 1990s, many countries in the developed world achieved greater central bank independence: Japan, South Korea, New Zealand, Sweden, the UK, etc. Intermediate Macroeconomics

6. The Trend Toward Inflation Targeting • Five components of IT (Mishkin2004): • The public announcement of medium-term numerical targets for inflation, • An institutional commitment to price stability as the primary goal of monetary policy, • An information-inclusive strategy to set policy instruments, • Increased transparency of the monetary policy strategy, and • Increased accountability of central bank for attaining its inflation objectives. • Inflation targeting was first adopted by New Zealand in 1990. By 2006, a total of 24 countries had adopted IT. Intermediate Macroeconomics

7. Increasing Attention on Financial Stability • Early central banks (e.g., Riksbank, Bank of England), with substantial commercial banking business, focus on the nature and quality of bank assets, primarily the commercial bills. They do not focus on direct examination of the books or the management practices of other commercial banks. • Banking crises during the interwar period led to establishment of institutions with responsibility for bank supervision, some within the central bank, some separate, and others only formally separate. • From late 1960s, resurgent financial instabilities, often international, reinforced the role of central banks in designing the regulations, monitoring that rules were followed, imposing sanctions if rules were violated, and being the lender of last resort if crises occurred. • Since 1980s, under the influence of the free-market ideology, financial regulation failed to catch up with “financial innovations”. • The recent global financial crisis once again reinforced central banks’ attention on financial stability. Intermediate Macroeconomics

8. The Art of Monetary Policy • Monetary policy will always need some “judgment”. • Formal models may be able to use only a small subset of data that are informative on our complex economy. • High-frequency data • Anecdotal observations (Beige Book of the US Fed) • Model selection problem: economists are never sure which model or which modeling approach is the correct one. • Model instability problem: a model may be correct for a time and fails next period after some structural change in the economy. Intermediate Macroeconomics