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This lecture examines the issues related to pegging the rate of interest and explores Friedman's argument on the instability it causes. The lecture also confirms the Sargent-Wallace finding on the instability of an interest rate peg with rational expectations. It further discusses the feasibility of an interest rate target under rational expectations.

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## Problems with Interest Rate Pegging and Friedman's Critique

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**Lecture 7**Intermediate Targets, Money Supply or Interest rates?**Examine the problems related to the pegging of the rate of**interest • Examine Friedman’s argument in the context of adaptive expectations. • Confirm the Sargent- Wallace finding for the instability of an interest rate peg with rational expectations • Show that an interest rate target is feasible under RE**The Friedman critique of interest rate pegging**• Friedman showed that pegging the rate of interest leads to instability of inflation and output • The argument owes a lot to Thornton (1806) and Wicksell • A positive real shock can lead to accelerating inflation and above capacity growth.**The model**• Let m = money, y = output, r = real rate of interest, R = nominal rate of interest and = rate of inflation (e = expected inflation) • R = r + e • Let the demand for money be given by md - p = y - R • Let the IS curve be y = -r • Let the ‘Phillips’ curve be = (y-y*)+ e**Instability of of the interest rate peg with Adaptive**Expectations**A positive IS curve shock**R LM R* IS(e)’ IS+u IS Y Y***Sargent & Wallace confirm the same result with RE**• Should the monetary authorities use the interest rate or the money supply as its instrument of control? • It depends on the flexibility of prices and relative magnitudes of demand (real) versus nominal shocks • S&W show that if money is the instrument of control, there is a determinate price level • If R is the control variable, there is not.**McCallum (1981) (1986)**• If the monetary authorities follow an interest rate rule, it is possible to obtain a determinate price level. • mt = m* + a(Rt-R*) • In a simple model with a forward expectations IS curve and a LM curve and a price surprise supply curve. • There is a deterministic solution and a stochastic solution**Monetary Policy - intermediate targets**• The role of monetary policy in a stochastic environment • The intermediate target - money supply or interest rate to stabilise output? • When is the money supply the most appropriate intermediate target? • When the interest rate? • When a combination?**Assumptions**• Authorities know the structure of the economy • Uncertainty is additive • Shocks to the IS curve are given by u and E(u) = 0 and E(u)2 = 2u • Shocks to the LM curve are given by v and E(v)=0 and E(v)2 = 2v • The price level is fixed and we are in the short-run**IS-LM Model**• IS Schedule y = y0 - R + u • LM Schedule m = y - R + v • A positive u shifts the IS curve up • A positive v shifts the LM up to the left.**u, v > 0**LM+v R LM IS+u IS y**R* with only IS shocks**R R* IS+u IS IS-u Y**R* with only LM shocks**LM+v • R LM LM-v R* Y Y***M* with only IS shocks**• R LM IS+u IS IS-u Y**M* with only LM shocks**• R LM+v LM LM-v IS Y**If only IS shocks - which is best intermediate target?**• R LM IS-u R* IS+u IS Y**If LM shocks only - which is best intermediate target?**• R LM+v LM LM-v R* IS Y* Y**Combination policy**• R LM if IS shocks only LM if IS & LM shocks LM if LM shocks only IS Y**Summary**• Interest rate is best intermediate target if LM shocks dominate • Money supply is best intermediate target if IS shocks dominate • Combination policy is superior to both if shocks come from both IS and LM

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