Monetary Policy Design & Practice: Optimizing Inflation Rate & Fed's Tools

1. Chapter 25: Monetary Policy: A Summing Up 26-1 The Optimal Inflation Rate 26-2 The Design of Monetary Policy 26-3 The Fed in Action Dr Tufte's ECON 3020 Using Blanchard's Text

2. 25-1 The Optimal Inflation Rate • The Costs of Inflation • The Benefits of Inflation • The Optimal Inflation Rate: The Current Debate Dr Tufte's ECON 3020 Using Blanchard's Text

3. The Costs of Inflation • Shoe leather costs • Changing prices costs real money • Chasing low prices costs real money • Tax distortions • Money illusion • Variability of inflation is an additional cost Dr Tufte's ECON 3020 Using Blanchard's Text

4. The Benefits of Inflation • Seignorage • Negative real interest rates are attainable • Inflation benefits borrowers and may boost investment and therefore output • Attaining negative real rates may be difficult because banks know it is in their best interest to raise nominal rates to cover inflation • Money illusion • This is a good thing for an economy since real wages are continuously reduced – this eliminates problems for managers with workers whose real value has dropped Dr Tufte's ECON 3020 Using Blanchard's Text

5. The Optimal Inflation Rate: The Current Debate • Shoe leather costs and money illusion are not serious costs at low inflation rates • Tax distortions are solvable without changing the inflation rate • Most countries avoid systematically exploiting seignorage, and negative real interest rates are difficult to attain. • Currently, we think that a 1-3% inflation rate is desirable, because of the benefits of money illusion Dr Tufte's ECON 3020 Using Blanchard's Text

6. 25-2 The Design of Monetary Policy • Money Growth and Inflation Revisited • From Money to Monetary Aggregates • Taylor’s Rule Dr Tufte's ECON 3020 Using Blanchard's Text

7. Money Growth and Inflation Revisited • In principle, the central bank should be able to choose the desired rate of inflation, and then set money growth to match it. • Unfortunately, M1 and inflation don’t match up well Dr Tufte's ECON 3020 Using Blanchard's Text

8. From Money to Monetary Aggregates • Broader monetary aggregates track inflation better, but not well • Additionally, the Fed only controls part of M1, and none of the additional components of broader aggregates • Perhaps central banks should target inflation directly, and not worry about the rate of money creation Dr Tufte's ECON 3020 Using Blanchard's Text

9. Taylor’s Rule • Taylor proposed a rule for interest rate targeting that later estimates indicated was a good description of monetary policy • i = i* + a(p – p*) – b(u-un) • The asterisks indicate a desired value • Estimates for the U.S. indicate that a ~ 1.5, and b ~ 1 • The 2% interest rate cut suggests that : • 1) unemployment is going to go up by 2 points, • 2) inflation can safely go up by 1.33 points, or • 3) some combination of those Dr Tufte's ECON 3020 Using Blanchard's Text

10. 25-3 The Fed in Action • The Mandate of the Fed • The Organization of the Fed • The Instruments of Monetary Policy • The Practice of Policy • Could the Conduct of U.S. Monetary Policy be Improved? Dr Tufte's ECON 3020 Using Blanchard's Text

11. The Mandate of the Fed • The Humphrey-Hawkins act requires the Fed to promote: • Maximum employment • Stable prices • Moderate long-term interest rates • There is an expectation that this will be addressed, but it is enforced only by having the Fed chairman speak to Congress once a year Dr Tufte's ECON 3020 Using Blanchard's Text

12. The Organization of the Fed • Board of Governors • Seven appointed members in Washington • Reserve Banks • Twelve scattered around the country • Federal Reserve Open Market Committee • Seven board members, plus five of the twelve bank presidents • Open Market Desk • Part of the Federal Reserve Bank of New York • Charged with carrying out FOMC directives Dr Tufte's ECON 3020 Using Blanchard's Text

13. The Instruments of Monetary Policy • Reserve requirements • Rarely changed because it would affect banks debt management choices • Discount borrowing (directly from the Fed) • Discouraged by a regulatory threat • The Federal Funds market exists to fill this role • Open market operations • Basic technique for achieving FOMC directives Dr Tufte's ECON 3020 Using Blanchard's Text

14. The Practice of Policy • The FOMC issues two types • Every six weeks they announce a target for the Federal Funds rate • Annually, they announce targets for growth of monetary aggregates • The Open Market Desk: • Carries out the former almost immediately • Uses the latter as a guideline Dr Tufte's ECON 3020 Using Blanchard's Text

15. Could the Conduct of U.S. Monetary Policy be Improved? • People familiar with the history of monetary policy do not think we could do much better than we have over the last 22 years • The Volker and Greenspan tenures • One problem worth worrying about is that a lot of the Fed’s recent success is attributed directly to Alan Greenspan • What happens if he retires? Dr Tufte's ECON 3020 Using Blanchard's Text

16. Could the Conduct of U.S. Monetary Policy be Improved? Cont’d • Fed policy has been instrumental in: • Reducing inflation after the 1970’s • Avoiding recession in 1986 • Mitigating the negative effects of the 1987 stock market crash • Mitigating the negative effects of the S&L bailout crisis • Softening the 1990-1 recession • Restoring confidence to markets during the 1997-8 Asian crisis Dr Tufte's ECON 3020 Using Blanchard's Text