Figure 14.1
a. This strategy works well if the main shocks to the economy are to the LM curve
(shocks to money supply or money demand)
b. The strategy stabilizes output, the real interest rate, and the price level, as it offsets the
there is substantial uncertainty about what the level of the optimal Fed funds rate is
on any given date
6. The LR curve
a. If the Fed is targeting a real interest rate, then a modification of the LM curve will
simplify our analysis
(1) We can replace the LM curve with a horizontal line drawn at the target real interest
rate, rT (Figure 14.3; text Figure 14.10). The horizontal line is labeled LR
1. In fact, it isn’t so easy because of lags in the effect of policy and uncertainty about the state
of the economy, economic models, and expectations
1. It takes a fairly long time for changes in monetary policy to have an impact on
the economy
2. Interest rates change quickly, but output and inflation barely respond in the first four months
after the change in money growth (text Figure 14.11)
3. Tighter monetary policy causes real GDP to decline sharply after about four months, with
the full effect being felt about 16 to 20 months after the change in policy
4. Inflation responds even more slowly, remaining essentially unchanged for the first year,
then declining somewhat
5. These long lags make it very difficult to use monetary policy to control the economy very
precisely
6. Because of the lags, policy must be made based on forecasts of the future, but forecasts are
often inaccurate
7. The Fed has made preemptive strikes against inflation based on forecasts of higher future
inflation
Policy Application
Alan Blinder, an economist from Princeton University who served several years in the Federal
1. Uncertainty about state of economy
a. Conflicting signals from data
2. Incomplete models of the economy
a. No one knows the best model that describes the economy (classical vs. Keynesian,
slopes and locations of curves, levels of full-employment output and natural rate of
unemployment)
3. Uncertainty about how expectations of public will be affected by shocks and policy
actions
1. The housing crisis, which began in 2007, led to losses at financial institutions, but no one
thought it would lead to a major financial crisis
2. In the Great Recession, the economy deteriorated rapidly in late 2008 and early 2009; the
recession rivaled those of 1973-1975 and 1981-1982, and the recovery from the recession
3. The Zero Lower Bound
a. The Fed cut interest rates to near zero by the end of 2008, hitting the zero lower bound
b. In such a liquidity trap, increases in the money supply are held by banks or the public,
and have no effect on spending
c. To escape the problems caused by the zero lower bound, the Fed took unusual policy
1. Financial institution troubles that began in 2007 represented a shock, shifting the IS curve
down and to the left as housing investment declined
2. Banks began to reduce credit availability because of worries that some financial
institutions were no longer viable because of losses on mortgage-backed securities; in
3. The recession that began in December 2007 seemed mild through September 2008, but
then failures at Fannie Mae, Freddie Mac, Lehman Brothers, and AIG led to panic by
4. The panic led to a sharp decline in investment, shifting the IS curve further down and to
the left, so the Fed cut its interest rate target sharply, trying to shift the LM curve down
1. Rules make monetary policy automatic, as they require the central bank to set policy based
on a set of simple, prespecified, and publicly announced rules
2. Examples of rules
a. Increase the monetary base by 1% each quarter
3. The rule should be simple; there shouldn’t be much leeway for exceptions
4. The rule should specify something under the Fed’s control, like growth of the monetary base,
not something like fixing the unemployment rate at 4%, over which the Fed has little control
5. The rule may also permit the Fed to respond to the state of the economy
B. Most Keynesian economists support discretion
1. Discretion means the central bank looks at all the information about the economy and uses its
judgment as to the best course of policy
2. Discretion gives the central bank the freedom to stimulate or contract the economy when
needed; it is thus called activist
3. Since discretion gives the central bank leeway to act, while rules constrain its behavior,
why would anyone suggest that the central bank follow rules?
1. Monetarism is an economic theory emphasizing the importance of monetary factors
in the economy
2. The leading monetarist is Milton Friedman, who has argued for many years (since 1959)
that the central bank should follow rules for setting policy
3. Friedman’s argument for rules comes from four main propositions
a. Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the
longer run, however, changes in the money supply have their primary effect on the price
level
(1) This proposition comes from Friedman’s research with Anna Schwartz on monetary
1. New arguments for rules suggest that rules are valuable even if the central bank has a lot of
information and forms policy wisely
2. Rules, commitment, and credibility
a. How does a central bank gain credibility?
b. One way to get credibility is by building a reputation for following through on its
promises, even if it’s costly in the short run
c. Another, less costly, way is to follow a rule that is enforced by some outside agency
1. John Taylor of Stanford University introduced a rule that allows the Fed to take economic
conditions into account
2. The rule is i 0.02 0.5y 0.5 ( 0.02), (14.6)
where i is the nominal Fed funds rate, is the inflation rate over the last 4 quarters,
( )/y Y Y Y= – =
the percentage deviation of output from full-employment output
3. The rule works by having the real Fed funds rate (i ) respond to:
a. y, the difference between output and full-employment output
4. If either y or increase, the real Fed funds rate is increased, causing monetary policy to
tighten (and vice-versa)
5. Taylor showed that the rule is similar to what the Fed does in practice
6. Taylor advocates the use of the rule as a guideline for policy, not something to be followed
mechanically
7. The data show that in the 1960s and 1970s when the Fed set the Federal funds rate below the
rule’s suggestion, inflation rose; when the Fed set the Federal funds rate fairly close to the
8. In the 2000s, the Fed kept the Federal funds rate below the level suggested by the rule
because of concerns about deflation
9. Economists are experimenting with variations on the original rule, using forecasts rather than
past data and looking at different coefficients in the rule
10. Uncertainty about the output term in the Taylor rule is large because of data revisions and
uncertainty about potential output in real time
1. Appointing a “tough” central banker
a. Appointing someone who has a well-known reputation for being tough in fighting
2. Changing central bankers’ incentives
3. Increasing central bank independence
a. If the executive and legislative branches of government can’t interfere with the central
bank, people are more likely to believe that the central bank is committed to keeping
inflation low and won’t cause a political business cycle
1. Since 1989, some countries have adopted a system of inflation targeting
2. New Zealand was the pioneer, announcing explicit inflation targets that had to be met or else
the central bank’s governor could be fired
1 to 4 years
d. The major disadvantage of inflation targeting is that inflation responds to policy actions
with a long lag, so it’s hard to judge what policy actions are needed to hit the inflation
target and hard for the public to tell if the central bank is doing the right thing, so central
banks may miss their targets badly, losing credibility
6. The LR curve
a. If the Fed is targeting a real interest rate, then a modification of the LM curve will
simplify our analysis
(1) We can replace the LM curve with a horizontal line drawn at the target real interest
rate, rT (Figure 14.3; text Figure 14.10). The horizontal line is labeled LR
1. In fact, it isn’t so easy because of lags in the effect of policy and uncertainty about the state
of the economy, economic models, and expectations
1. It takes a fairly long time for changes in monetary policy to have an impact on
the economy
2. Interest rates change quickly, but output and inflation barely respond in the first four months
after the change in money growth (text Figure 14.11)
3. Tighter monetary policy causes real GDP to decline sharply after about four months, with
the full effect being felt about 16 to 20 months after the change in policy
4. Inflation responds even more slowly, remaining essentially unchanged for the first year,
then declining somewhat
5. These long lags make it very difficult to use monetary policy to control the economy very
precisely
6. Because of the lags, policy must be made based on forecasts of the future, but forecasts are
often inaccurate
7. The Fed has made preemptive strikes against inflation based on forecasts of higher future
inflation
Policy Application
Alan Blinder, an economist from Princeton University who served several years in the Federal
1. Uncertainty about state of economy
a. Conflicting signals from data
2. Incomplete models of the economy
a. No one knows the best model that describes the economy (classical vs. Keynesian,
slopes and locations of curves, levels of full-employment output and natural rate of
unemployment)
3. Uncertainty about how expectations of public will be affected by shocks and policy
actions
1. The housing crisis, which began in 2007, led to losses at financial institutions, but no one
thought it would lead to a major financial crisis
2. In the Great Recession, the economy deteriorated rapidly in late 2008 and early 2009; the
recession rivaled those of 1973-1975 and 1981-1982, and the recovery from the recession
3. The Zero Lower Bound
a. The Fed cut interest rates to near zero by the end of 2008, hitting the zero lower bound
b. In such a liquidity trap, increases in the money supply are held by banks or the public,
and have no effect on spending
c. To escape the problems caused by the zero lower bound, the Fed took unusual policy
1. Financial institution troubles that began in 2007 represented a shock, shifting the IS curve
down and to the left as housing investment declined
2. Banks began to reduce credit availability because of worries that some financial
institutions were no longer viable because of losses on mortgage-backed securities; in
3. The recession that began in December 2007 seemed mild through September 2008, but
then failures at Fannie Mae, Freddie Mac, Lehman Brothers, and AIG led to panic by
4. The panic led to a sharp decline in investment, shifting the IS curve further down and to
the left, so the Fed cut its interest rate target sharply, trying to shift the LM curve down
1. Rules make monetary policy automatic, as they require the central bank to set policy based
on a set of simple, prespecified, and publicly announced rules
2. Examples of rules
a. Increase the monetary base by 1% each quarter
3. The rule should be simple; there shouldn’t be much leeway for exceptions
4. The rule should specify something under the Fed’s control, like growth of the monetary base,
not something like fixing the unemployment rate at 4%, over which the Fed has little control
5. The rule may also permit the Fed to respond to the state of the economy
B. Most Keynesian economists support discretion
1. Discretion means the central bank looks at all the information about the economy and uses its
judgment as to the best course of policy
2. Discretion gives the central bank the freedom to stimulate or contract the economy when
needed; it is thus called activist
3. Since discretion gives the central bank leeway to act, while rules constrain its behavior,
why would anyone suggest that the central bank follow rules?
1. Monetarism is an economic theory emphasizing the importance of monetary factors
in the economy
2. The leading monetarist is Milton Friedman, who has argued for many years (since 1959)
that the central bank should follow rules for setting policy
3. Friedman’s argument for rules comes from four main propositions
a. Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the
longer run, however, changes in the money supply have their primary effect on the price
level
(1) This proposition comes from Friedman’s research with Anna Schwartz on monetary
1. New arguments for rules suggest that rules are valuable even if the central bank has a lot of
information and forms policy wisely
2. Rules, commitment, and credibility
a. How does a central bank gain credibility?
b. One way to get credibility is by building a reputation for following through on its
promises, even if it’s costly in the short run
c. Another, less costly, way is to follow a rule that is enforced by some outside agency
1. John Taylor of Stanford University introduced a rule that allows the Fed to take economic
conditions into account
2. The rule is i 0.02 0.5y 0.5 ( 0.02), (14.6)
where i is the nominal Fed funds rate, is the inflation rate over the last 4 quarters,
( )/y Y Y Y= – =
the percentage deviation of output from full-employment output
3. The rule works by having the real Fed funds rate (i ) respond to:
a. y, the difference between output and full-employment output
4. If either y or increase, the real Fed funds rate is increased, causing monetary policy to
tighten (and vice-versa)
5. Taylor showed that the rule is similar to what the Fed does in practice
6. Taylor advocates the use of the rule as a guideline for policy, not something to be followed
mechanically
7. The data show that in the 1960s and 1970s when the Fed set the Federal funds rate below the
rule’s suggestion, inflation rose; when the Fed set the Federal funds rate fairly close to the
8. In the 2000s, the Fed kept the Federal funds rate below the level suggested by the rule
because of concerns about deflation
9. Economists are experimenting with variations on the original rule, using forecasts rather than
past data and looking at different coefficients in the rule
10. Uncertainty about the output term in the Taylor rule is large because of data revisions and
uncertainty about potential output in real time
1. Appointing a “tough” central banker
a. Appointing someone who has a well-known reputation for being tough in fighting
2. Changing central bankers’ incentives
3. Increasing central bank independence
a. If the executive and legislative branches of government can’t interfere with the central
bank, people are more likely to believe that the central bank is committed to keeping
inflation low and won’t cause a political business cycle
1. Since 1989, some countries have adopted a system of inflation targeting
2. New Zealand was the pioneer, announcing explicit inflation targets that had to be met or else
the central bank’s governor could be fired
1 to 4 years
d. The major disadvantage of inflation targeting is that inflation responds to policy actions
with a long lag, so it’s hard to judge what policy actions are needed to hit the inflation
target and hard for the public to tell if the central bank is doing the right thing, so central
banks may miss their targets badly, losing credibility