1. Chapter Eighteen Rules for Monetary Policy

2. Rules for Monetary Policy • If monetary policy were predictable, people and businesses could make better informed decisions • A rule for monetary policy is a systematic setting of policy according to a formula • If monetary policy is not set by rule, it is said to be set by discretion • May ease policy (increasing money supply) or tighten (decreasing money supply) policy

3. The Expectations Trap • Expectations trap: occurs when policymakers must increase inflation in response to an increase in the expected inflation rate • Example: People expect higher inflation, so wages rise; if the Fed does not increase inflation, real wages are too high, so unemployment then rises • But why do people expect higher inflation?

4. The Expectations Trap (cont’d) • Why do people expect higher inflation? • Fed is easing monetary policy before an election to aid the incumbent • Potential output growth has slowed without policymakers realizing it, causing them to erroneously think the output gap is negative

5. Time Inconsistency • A more subtle reason to explain why people expect the Fed to ease monetary policy • Time inconsistency is the is the difficulty that arises when a policy is chosen at date t, then people make a choice based on that policy, and then policymakers have incentive to change policy at a different date • Example: one-time gains from fooling people • If people anticipate a time-inconsistent incentive, they will ignore the first policy

6. Credibility • Central banks need credibility if they want to avoid time-inconsistent policies • Ways the Fed could achieve credibility • Its only goal is low inflation • Fed is (even more) independent from politics • Chooses conservative policymakers • Establishing a good reputation over time • If the Fed cannot achieve credibility, the alternative to time inconsistency is commitment, or a monetary policy rule

7. Commitment • Following a rule “ties the hands” of the central bank • But if the bank itself sets the rule, it is difficult to truly tie their hands • Example: Argentine currency board pegging the peso to the dollar…Such a policy actually eliminates monetary policy • Discretion is the ultimate source of time inconsistency

8. Money-Growth Rules • The first type of rule proposed by monetarists in 1960s was the money-growth rule • A money growth rule focuses only in the growth rate of money in the long run, ignoring short run fluctuations • Example: money growth = 3% every year • Such a rule is based on the equation of exchange

9. The Equation of Exchange • The equation of exchange is based on idea that the money in circulation must be used a certain number of times to support a given amount of spending M × V = P × Y • Velocity = number of times the average dollar is spent on final goods and services

10. Money-Growth Targets %M + % V = %P + %Y =  + %Y Money growth + velocity growth = inflation rate + output growth • Monetarists believe velocity is stable or at least predictable %ΔM = πT + %ΔY* - %ΔVe πT = inflation target %ΔY* = growth rate of potential output %ΔVe = expected growth rate of velocity

11. Instability of Money-Growth Rule • Financial innovations sometimes alter the relationship between money and other variables, such as the introduction of interest-bearing checking accounts • As a result, velocity has become unstable in the 1980s and 1990s. • Economists had been paying more attention to M2 than to M1

12. Instability of Money-Growth Rule (cont’d) Figure 18.1 M1 Growth, M1 Velocity Growth, and the Inflation Rate M1 growth and velocity changed drastically beginning the 1980s, without leading to increased inflation

13. Instability of Money-Growth Rule (cont’d) Figure 18.2 M2 Growth, M2 Velocity Growth, and the Inflation Rate M2 growth rate trended up in the 1990s, also without leading to increased inflation

14. Activist Versus Non-Activist Rules • Activist rules: allow for changes in monetary policy in response to business cycle fluctuations • Non-activist rules: keeping monetary policy unchanged in response to business cycle fluctuations • Monetarists believed in non-activist rules • Policymakers have sought a rule that was simple but that allowed for some activism

15. The Taylor Rule • The Taylor Rule suggests that monetary policy sets the federal funds rate in response to deviations in real output and inflation from their targets i = r* + π + (w1 × Y~) + (w2 × π~) • Thus the nominal ffr is increased if positive output or inflation gaps exist, and vice versa • Intuition: set funds rate at long-run average; deviate for gaps

16. The Taylor Rule (cont’d)

17. The Taylor Rule (cont’d) • It is activist, so liked by Keynesians, and a rule, so liked by classical economists • Potential difficulties • Hard to know potential output (hence output gap) in real time • Optimal weights depend on the model used • Equilibrium real interest rate may not be historical average • Data revisions affect rule settings

18. The Taylor Rule (cont’d) Figure 18.3a Actual Federal Funds Rate and the Taylor Rule Recommendation A policymaker following the Taylor Rule would have wanted tighter policy in the 50s-70s and early 2000s, and easier policy in the 80s and 90s

19. Inflation Targeting • Inflation targeting is a system in which a central bank tries to achieve an explicit target for inflation within a given time period • Steps in inflation targeting • picks a target band for the inflation rate • gets the inflation rate within the band within a specified period • maintains the inflation rate within the band thereafter

20. Inflation Targeting (cont’d) • New Zealand was the first country to use inflation targeting • 1990: target 3 to 5% • 1991: target 2.5 to 4.5% • 1992: target 1.5 to 3.5% • Now: target 0 to 3% • Failure to hit targets could lead to dismissal of central bank governor

21. Inflation Targeting (cont’d) Advantages of Inflation Targeting • Provides credibility; makes goals of central bank transparent • Inflation report keeps public informed of progress, removes some time inconsistency problems • Reduces uncertainty faced by investors about short-term interest rates

22. Inflation Targeting (cont’d) Disadvantages of Inflation Targeting • Reduces flexibility of the central bank, especially because central bank also cares about output in the short run • Requires the use of inflation forecasts, which may not be accurate • Necessitates difficult choices on how quickly to reduce inflation post-shock • Some countries allow target to be deviated from in times of recession