The Optimal Inflation Rate? • Inflation has steadily gone down in rich countries since the early 1980s. • Should inflation be reduced even further?
The Costs of Inflation • Shoe-leather costs are the costs of making more trips to the bank. • Tax distortions occur when tax rates do not increase automatically (bracket creep). • Money illusion: people make systematic mistakes in assessing nominal versus real changes. • Inflation variability: financial assets such as bonds, which promise fixed nominal payments in the future, become riskier.
The Benefits of Inflation • Seignorage, or the revenues from money creation, allow the government to borrow less from the public, or to lower taxes. • Seignorage income for the U.S. • The presence of inflation allows for downward real-wage adjustments more easily than when there is no inflation.
The Optimal Inflation Rate:The Current Debate • Those who aim for small but positive inflation argue that some of the costs of positive inflation can be avoided, and the benefits are worth keeping. • Those who aim for zero inflation argue that this amounts to price stability, which simplifies decisions and eliminates money illusion. • Today, most central banks appear to be aiming for a low but positive inflation, between 2 and 4%.
Official Goals of the Fed • Promote Maximum Employment • Maintain Stable Prices • Achieve Moderate Long-Term Interest Rates
The Design of Monetary Policy: Money Growth • The choice of an optimal inflation rate determines the rate of nominal money growth. • The central bank may want to announce a target for nominal money growth, and make it clear how it would deviate from it to address short-run fluctuations. • Until recently, this is how monetary policy has been conducted in most countries.
Money Growth and Inflation Revisited • The design of monetary policy around nominal money growth is based on the assumption that a close relation between inflation and nominal money growth exists in the medium run. • The problem is that this relation is not very tight.
M1 Growth and Inflation M1 Growth and Inflation: 10-year averages 1970-2000
The Design of Monetary Policy: Inflation Targeting • Many central banks have defined as their primary, and sometimes exclusive goal, the achievement of a low inflation rate. • Inflation targeting would lead the central bank to act in such a way as to eliminate all deviations of output from the natural level of output.
The Design of Monetary Policy: Interest Rate Targeting • Taylor’s Rule: According to Taylor, since it is the interest rate that directly affects spending, the central bank should choose an interest rate rather than a rate of nominal money growth. • If , then the central bank should set it equal to its target value, i*. and
Taylor’s Rule • The higher the value of a, the more the central bank will increase the interest rate in response to inflation. • The higher the value of b, the more the central bank will be willing to deviate from target inflation to keep unemployment close to the natural rate. • In sum, these coefficients reflect how much the central bank cares about unemployment versus inflation.
Taylor’s Rule • Taylor’s rule provides a way of thinking about monetary policy: once the central bank has chosen a target rate of inflation, it should try to achieve it by adjusting the nominal interest rate. • This rule actually describes quite well the behavior of many central banks in the past 15-20 years.
The Organization of the Fed • The Federal Reserve System is composed of three parts: • A set of 12 Federal Reserve Districts • The Board of Governors (7 members) • The Federal Open Market Committee (FOMC).
The Instruments of Monetary Policy • The equilibrium interest rate is the interest rate at which the supply and the demand for central bank money are equal. • The money supply, refers to the monetary base. • The demand for money is the sum of the demand for currency and the demand for reserves by banks.
1. Reserve Requirements • Reserve requirements are the minimum amount of reserves that banks must hold in proportion to checkable deposits. • By changing reserve requirements, the Fed effectively changes the demand for central bank money. • This instrument of monetary policy is not widely used because banks may take drastic actions to increase their reserves, such as recalling some of the loans.
2. Lending to Banks • The Fed can also lend to banks, thereby affecting the supply of central bank money. • The set of conditions under which the Fed lends to banks is called discount policy. The Fed lends at a rate called the discount rate, through the discount window. • Today, changes in the discount rate are used mostly as a signal to financial markets.
3. Open-Market Operations • Open-market operations, the purchase and sale of government bonds in the open market, is the main instrument of U.S. monetary policy. It is convenient and flexible. • When the Fed buys bonds, it pays for them by creating money, thereby increasing the money supply, H. When it sells bonds, it decreases H.
The Fed can pursue expansionary monetary policy by… …open market purchases of bonds. or …reducing the discount rate. or …reducing banks’ reserve requirement. All of these will result, in the short run, in the LM curve shifting to the right.
The Practice of Policy • The most important monetary policy decisions are made at meetings of the FOMC. • Fed staff prepares forecasts and simulations of the effects of different monetary policies on the economy, and identifies the major sources of uncertainty. • The conduct of open-market operations between FOMC meetings is left to the Open Market Desk.
The Practice of Policy • Does the Fed have a money growth target, an inflation target, or follow an interest rate rule? • The answer: we don’t know.