978-0133780581 Chapter 23 Lecture Note

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CHAPTER 23. MONETARY POLICY: A SUMMING UP

I. MOTIVATING QUESTION

What do macroeconomists know about monetary policy?

In the long run, monetary policy affects only the inflation rate. Thus, a central bank should adopt a target inflation

rate, based on the costs and benefits of inflation. In the short run, however, monetary policy affects output, so the

central bank must decide whether to deviate from its target to respond to economic shocks. Before the crisis, this

decision depends on the degree to which the central bank cares about fluctuations in unemployment and inflation.

It is now believed that the crisis has thus presented countries with the challenge of the liquidity trap and

new processes to achieve macroeconomic stability beyond stable inflation.

II. WHY THE ANSWER MATTERS

Whether the central bank should change interest rates or offer new macroeconomic prudential tools are the

preeminent macroeconomic policy issues. This chapter provides a basis to think about this question, in light of the

long-run objectives of the central bank. Moreover, the crisis has questioned many countries’ monetary

policymaking decision making tools. Looking forward, should the central bank worry not only about

inflation and the overall level of economic activity but also about asset prices, stock market booms,

housing booms, and creating and implementing regulations to avoid excessive risk in the financial

sector? And if so, what tools does it have at its disposal?

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The chapter introduces monetary aggregates. M1 is the sum of currency and checkable deposits. M2 is

the sum of M1, money market mutual fund shares, money market deposit accounts, and time deposits.

ii. The Taylor rule argues that central banks should deviate from their target interest rates to the extent that

they care about short-run fluctuations in inflation and unemployment.

iii. The chapter introduces terminology associated with the organization of the U.S. Federal Reserve.

iv. Quantitative easing is presented as an unconventional monetary policy tool.

v. Macro prudential tools are rules aimed directly at borrows or lenders, or banks and other financial

institutions as the case may require.

IV. SUMMARY OF THE MATERIAL

1. What We Have Learned

The analysis in previous chapters suggests that the short-run effects of monetary policy are different from the

medium-run and long-run effects. In the short run, expansionary monetary policy lowers interest rates and causes

the exchange rate to depreciate. As a result, output and the price level increase. In the medium and long run,

money growth determines inflation, but has no effect on output. Thus, the medium-run inflation rate is

determined by the medium-run rate of growth of the money supply. With this in mind, the Federal Reserve has to

choose a rate of inflation to target in the medium run and to decide when and by how much to deviate from this

target in the short run.

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2. From Money Targeting to Inflation Targeting

Until the 1990s, central bankers typically thought about monetary policy in terms of the rate of money growth. A

central bank chose a rate of money growth that corresponded to its inflation target, and worried about how closely

the growth of monetary aggregates matched its goals. But it turns out that money demand does not have a stable

relationship with any of the monetary aggregates. As a result, inflation does not have a tight relationship with the

growth of any particular monetary aggregate. Faced with this reality, most central banks now think about

monetary policy in terms of the nominal interest rate. A central bank tries to achieve its target inflation rate by

changing the interest rate.

In the short run, an inflation target might seem to reduce the central bank’s flexibility to stabilize output. In

theory, this is not the case. If the central bank sees a recession arising from an adverse demand curve, it knows

that inflation will fall. Thus, it should pursue a monetary expansion to increase inflation. This policy of course

will also tend to return output to its natural level. Indeed, if the central bank manages to achieve a constant rate of

inflation, the accelerationist Phillips curve implies that unemployment is always at its natural rate. In practice,

central banks will not always be able to achieve their inflation targets in the short run. If inflation turns out to be

higher than the target, it is not clear that the central bank should try to reduce it, since to do so would require

higher unemployment. Moreover, the Phillips curve does not hold exactly. Sometimes inflation will increase

even when unemployment is at the natural rate. A strict inflation target would require the central bank to

undertake a monetary contraction and increase unemployment above the natural rate.

Given an inflation target for the medium run, a central bank must decide how to achieve it and under what

conditions to relax the target to respond to short-run fluctuations. John Taylor argues that a central bank should

think in terms of a target interest rate, since the interest rate affects spending, and suggests an implementation

rule. Under the Taylor rule, central banks set short-term interest rates according to

i = i* + a(π-π*) – b(u–un),

where π* is the target rate of inflation, i* is the interest rate associated with this target, and un is the natural rate of

unemployment. The coefficients a and b reflect how much the central bank cares about inflation versus

unemployment. Note that the coefficient a should be greater than one, because the real interest rate affects

spending. Thus, when inflation increases, the central bank must increase the nominal rate by a greater amount to

increase the real interest rate and reduce spending.

Basically, the Taylor rule says that the central bank should respond to short-run fluctuations to the extent it cares

about them. Taylor acknowledges that events could justify changing the nominal interest rate for reasons not

included in the rule. But he argues that the rule provides a useful way of thinking about monetary policy.

Evidence suggests that the Taylor rule describes quite well the actual behavior of the Fed and the Bundesbank

over the past 20 years, however they conceived of their policy decisions. Today it seems that most central banks

think in terms of interest rate rules rather than in terms of nominal money growth. Indeed, the growth rate of any

particular monetary aggregate seems to be of little concern to central banks or financial markets.

3. The Optimal Inflation Rate

The optimal medium-run inflation rate depends on the costs and benefits of inflation. The costs of inflation vary

with the level of inflation. Very high rates of inflation disrupt economic activity; low rates of inflation are much

less costly. Inflation creates four costs, all of which increase with the rate of inflation.

First, higher inflation leads to higher nominal interest rates, which cause people to economize on holdings of

money. This effort requires resources, referred to as shoe leather costs. Such costs can become quite large during

hyperinflation, but are unlikely to be very important when inflation is low.

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Second, when the tax system is not indexed, the real tax burden will depend on the rate of inflation. In the United

States, this issue applies in particular to nominal interest income and capital gains. The tax distortions created by

inflation affect the allocation of economic resources. Indexing the tax code to account for inflation could address

these issues.

Third, with inflation, real and nominal values diverge. Evidence suggests that people suffer from money illusion,

i.e., they make systematic errors in assessing nominal versus real changes. Thus, inflation leads people and firms

to make incorrect decisions.

Fourth, because higher inflation is associated with more variable inflation, nominal assets become riskier in real

terms. This cost could be avoided through increased reliance on indexed bonds (bonds whose nominal payments

are indexed to the inflation rate). A number of countries, including the United States, now issue indexed bonds.

Inflation also has three benefits. First, seignorage—the amount of resources the government collects by printing

money—increases at higher rates of inflation, at least over some initial range. But the amount of seignorage

available at low rates of inflation in countries with otherwise highly developed tax systems is too small to make

this a powerful argument for low—as opposed to zero—rates of inflation.

Second, since the nominal interest rate cannot fall below zero, inflation makes it possible for governments to

achieve negative real interest rates, an option that may be useful to stimulate output during a recession.

Third, money illusion may cause workers to resist nominal wage cuts, independent of the effects on the real wage.

As a result, ongoing inflation may be necessary to achieve the real wage cuts that are sometimes required to

reallocate labor across sectors.

At present the debate over the optimal inflation rate is between those who favor low inflation (say 3% or so) and

those who favor zero inflation. Those who favor low inflation argue that the costs of inflation are low in this

range and that some of these costs could be avoided by indexing the tax system and issuing more indexed bonds.

In addition, there are benefits to maintaining some inflation, and the cost of eliminating it (in terms of higher

unemployment for a time) may outweigh any future benefits. Those who favor zero inflation argue that such a

target corresponds to price stability, which simplifies decision-making and helps alleviate the time inconsistency

problem by establishing a simple and clear goal for monetary policy.

4. Unconventional Monetary Policy

When central banks became zero bound conventional monetary policy was no longer available as a tool. Central

banks developed unconventional strategies to affect economic change. For example, central banks began buying

financial assets other than short-term bonds. This increase in demand pushed prices higher and reduced

longer-term interest rates and stimulated consumption and investment. These asset purchase programs became

known as quantitative easing or QE. The primary assets purchased in three separate QE rounds were mortgage

backed securities and long term U.S. Treasuries. The end result was lower interest rates and a massive expansion

of the Fed’s balance sheet. Currently most of this money expansion is being held as excess bank reserves. The

Fed’s decision point is whether to return its balance sheet to pre-crisis levels or to gradually reduce asset holdings.

5. Monetary Policy and Financial Stability

Until 2007 most countries saw stable inflation, and output fluctuations that were smaller than they had been in the

past. Many central banks believed that inflation targeting provided them with a solid framework for monetary

policy. It is believed that the crisis has thus presented countries with the challenge of the liquidity trap and new

processes to achieve macroeconomic stability beyond stable inflation.

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Liquidity Provision and Lender of Last Resort

One of the functions of the Fed is to prevent bank runs and ensure continued confidence in the banking system.

Depositors need to feel that their money is safe and accessible. Deposit insurance and the Fed’s readiness to loan

banks funds to keep banks from liquidating assets to cover withdrawals (i.e. lender of last resort function).

Macro Prudential Regulation

The crisis has created a broad consensus that it is risky to wait and it is better to prevent high leverage. Also, it is

now believed that to deal with bubbles, credit booms, or dangerous behavior in the financial system, the interest

rate is not the right policy instrument. Many believe the interest rate is too blunt an instrument, affecting the

whole economy rather than resolving the problem at hand. The authors offer an analysis of new instruments,

which are called macroprudential tools. These tools are rules that are aimed directly at borrowers, lenders,

banks and/or other financial institutions. This chapter section concludes with possible examples of the forms that

macro prudential tools could take. There are many questions regarding how well these macro prudential tools

work and their interaction with traditional monetary policy tools. Lastly, there is debate over whether the control

should be under the central bank or a separate authority.

V. PEDAGOGY

Some instructors may prefer to teach this lecture in reverse, starting institution risks proceeding from there to

problems of short-run monetary policy making, and then turning to the issue of the optimal medium-run inflation

rate. This sequence has the pedagogical advantage of moving from the more concrete to the more abstract.

A second possibility involves breaking up this chapter and integrating its various parts into the discussion of

previous chapters. For example, as indicated in the Chapter 4 of the Instructor’s Manual, the institutional material

about the Federal Reserve System could be incorporated into the description of the money supply process. The

existence of near monies (described in a box) could also be integrated into the monetary policy discussion of

Chapter 4 as a way of motivating money demand shocks.

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