Economics Chapter 21 Adherence Monetary Policy Rules Involves Imposing Some

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Chapter 21

The Role of Expectations in Macroeconomic Policy

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline

Rational Expectations and Policy Making

Adaptive Expectations

Lucas Critique of Policy Evaluation

Econometric Policy Evaluation

Application: The Consumption Function

Policy Conduct: Rules or Discretion?

Discretion and the Time-Inconsistency Problem

Policy and Practice: The Political Business Cycle and Richard Nixon

The Case for Discretion

Policy and Practice: The Demise of Monetary Targeting in Switzerland

Constrained Discretion

The Role of Credibility and a Nominal Anchor

Benefits of a Credible Nominal Anchor

Application: A Tale of Three Oil Price Shocks

Approaches to Establishing Central Bank Credibility

Inflation Targeting

Policy and Practice: Ben Bernanke and the Adoption of Inflation Targeting

Chapter 21 The Role of Expectations in Macroeconomic Policy 241

Chapter Overview and Teaching Tips

Part Eight of the book examines the latest developments in business cycle theory that have been driven by

a greater focus on microeconomic foundations of macroeconomic analysis. Over the last thirty years, the

role of the public and the market’s expectations has moved to the front and center of the thinking about

To put rational expectations theory in context, the chapter starts by discussing an older theory, adaptive

expectations, which just states that expectations are formed from past realizations of the data. It then

defines rational expectations as the optimal forecast (best guess) of the future using all available

information. There are five key points to help students understand this concept. First, it is derived from

The chapter next uses the concepts above to outline one of the most important ideas in macroeconomics in

the last thirty years, the Lucas critique, which says that macro-econometric relationships based on past

data will change when the way policy is conducted is changed, so policy evaluation with these models can

be very misleading. The intuition behind the Lucas critique is illustrated in an application with a simple

example using the consumption function. There are numerous other examples, an instructor might want to

discuss in class.

The chapter next turns to a set of policy issues. The first is the debate over whether policy makers should

follow rules or instead conduct policy with complete discretion, in which policy is conducted on a day-to–

day basis. The argument for rules is based on the time-inconsistency problem, another one of the most

important ideas in macroeconomics over the last thirty years. The problem with discretion is that policy

The next policy issue the chapter discusses is the role of credibility and a nominal anchor. Here, the rational

expectations conclusion that expectations about policy affect inflation expectations is embedded in the AD/AS

model, which is then used to show that having a credible commitment to a nominal anchor produces better

outcomes on both inflation and output when there are either demand or supply shocks. To demonstrate to

242 Mishkin • Macroeconomics: Policy and Practice, Second Edition

The final section of the chapter discusses different approaches to establishing a credible nominal anchor.

The first is inflation targeting, which involves announcement of an inflation target objective, with a

commitment by the central bank to achieve it. I was a strong proponent of this policy framework when I

was a governor of the Federal Reserve. The Fed adopted inflation targeting in January 2012, as is

◼ Answers to End of Chapter Review Questions and Problems

Answers to Review Questions

Rational Expectations and Policy Making

1. Adaptive expectations theory holds that people base their expectations on past experience only. As a

result, expectations change slowly over time as past data changes. Rational expectations theory

Lucas Critique of Policy Evaluation

2. Lucas argued that using macro-econometric models to evaluate the effects of proposed changes in

economic policy is an invalid procedure because the coefficients in those models’ equations have

Policy Conduct: Rules or Discretion?

3. The time-inconsistency problem is the situation people experience of having perfectly good long-run

intentions but making short-run decisions that lead to quite opposite outcomes. Applied to policy

making, this problem arises when policy makers set a goal of long-run price stability but then

Chapter 21 The Role of Expectations in Macroeconomic Policy 243

4. Advocates of rules argue that they solve the time-inconsistency problem so that policy makers will

achieve good long-run economic outcomes, that they will prevent repeating serious policy mistakes

that have been made in the past, and that they will avoid political business cycles that might result if

The Role of Credibility and a Nominal Anchor

5. A nominal anchor is a nominal variable—for example, the inflation rate, the money supply, or an

exchange rate—that ties down the price level or inflation to help policy makers achieve price

6. Positive aggregate demand shocks shift the aggregate demand curve to the right, causing both

inflation and output to rise. Without a credible nominal anchor, the increase in inflation causes

expected inflation to rise, which shifts the short-run aggregate supply curve upward and causes the

inflation rate to increase further. With a credible nominal anchor, however, expected inflation does

Approaches to Establishing Central Bank Credibility

7. Inflation targeting has two basic purposes, to keep inflation under control and to increase the

credibility of monetary policy makers’ commitment to price stability. These are achieved by

8. In countries where inflation targeting has been adopted, it has strengthened the credibility of the

9. Central bank independence gives monetary policy makers more credibility by insulating them from

the political process so that they can focus on long-run concerns like price stability. Within a sample

of countries, those with the most independent central banks had the lowest inflation rates over the

244 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Answers to Problems

Rational Expectations and Policy Making

1. Nicole has been forming rational expectations during these last ten years. What makes a forecast an

optimal forecast is that all relevant information is used, not only past information. Although Nicole’s

2. Mark’s expectations about future mortgage rates will be about the same as the current average

mortgage rates because this is the only information included in his forecast. Gloria’s expectations will

Lucas Critique of Policy Evaluation

3. a. According to the rational expectation theory, individuals might interpret this increase in the

federal funds rate target as a signal that the Fed will commit to fight inflation. The increase in the

federal funds rate determines an increase in real interest rates in the short run and results in a

higher user cost of capital. Although this might reduce investment, it is possible that individuals

Policy Conduct: Rules or Discretion?

4. a. The benefit of sticking to a set of rules when following a diet include reaching a given goal,

probably defined in terms of a desired weight. The costs can be measured in terms of the lost

opportunities to savor tasty food or desserts. In this case, costs are short lived, although it is quite

easy to succumb to temptations. This could be compared to a central bank pursuing overly

Chapter 21 The Role of Expectations in Macroeconomic Policy 245

5. When a president has the authority to nominate or lay off the director of the central bank, it is quite

plausible that the conduct of monetary policy would be discretionary. Adherence to monetary policy

rules involves imposing some hardship on the economy sometimes. If the president can pressure the

The Role of Credibility and a Nominal Anchor

6. Announcements about the inflation targets and potential punishments for central bank officials are

crucial for inflation targeting. It is very important for the public to be able to check whether the target has

been reached or not. When central bank officials know that the public can easily check their performance,

7. This is a clear sign that the Fed enjoys a high level of credibility. This credibility was probably

earned through the last two decades. Although the Fed never explicitly stated an inflation target,

many people believe that Fed officials had an inflation target in their minds during this period. Even

Approaches to Establishing Central Bank Credibility

8. The statistical office’s mistake will obviously hurt the central bank’s credibility and will mean that

the inflation target was missed. Depending on the set of rules governing the central bank, some

officers might be dismissed. When pursuing an inflation target, accurate inflation measurement is

246 Mishkin • Macroeconomics: Policy and Practice, Second Edition

9. New Zealand’s experience is typical in the sense that right after the central bank was instructed to

focus on bringing inflation to low levels, some indicators deteriorated. Economic growth was low,

and unemployment increased for a short period of time, but later New Zealand enjoyed relatively

10. Monetary policy officials more concerned about fighting unemployment than inflation are usually

dubbed “inflation doves,” to illustrate their “soft” approach to inflation. If the majority of the Board

of Governors was composed of inflation doves, then most likely the public’s expectations’ about

◼ Answers to Data Analysis Problems

1. a. For 2013:Q2, actual inflation was 0.03 percent, and adaptive expectations forecast a 1.36 percent

inflation rate.

2. a. From 2012:Q3 to 2013:Q2, inflation averaged 1.43 percent, well below the current 2 percent

target. Over the two year horizon from 2011:Q3 to 2013:Q2, inflation averaged 1.90 percent, still

a bit below but much closer to the 2 percent target.

3. a. From July 2008 to July 2013, the price of a barrel of oil declined on average by 4.3 percent; from

2008:Q2 to 2013:Q2, inflation decreased modestly from 1.9 percent to 1.5 percent.

b. From January 1976 to January 1981, the price of a barrel of oil increased on average by 69.7

Chapter 21 The Role of Expectations in Macroeconomic Policy 247

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Application: The Consumption Function

Data Source

Lucas Jr., Robert E. and Thomas J. Sargent, “After Keynesian Macroeconomics”:

macroeconomic models were of no use in guiding policy. This paper was presented in 1978.

Official Website of the Nobel Prize, Press Release:

Discussion Question

Critics of the Dodd-Frank Act (a new set of regulations that affects the financial system) argue that it will

restrict the size of large, complex financial institutions, preventing them from exploiting economies of

scale. If you had a model based on past data that estimates the impact on financial intermediaries’

profitability over the long run, would this model still be relevant after these new regulations?

Answer: A model whose coefficients have been estimated using past data can yield reasonable estimates as

long as the underlying conditions remain the same. This means that the conduct of monetary policy,

B. For Information About Policy and Practice: The Political Business Cycle

and Richard Nixon

Data Source

Poole, William, “Monetary Control and the Political Business Cycle”:

Wall Street Journal, “How Much Do Election Shakeups Affect the Nation’s Economy?” (11/03/2006):

Discussion Question

Other countries do not have rules as clear as the United States with respect to the central bank’s

independence. Do you think the political business cycle will be more or less prevalent in these countries?

Answer: In countries in which the central bank is not as independent from politicians’ influence the

248 Mishkin • Macroeconomics: Policy and Practice, Second Edition

C. For Information About Policy and Practice: The Demise of Monetary

Targeting in Switzerland

Data Source

Dueker, Michael and Andreas M. Fischer, “Inflation Targeting in a Small Open Economy: Empirical

Bernanke, Ben S. and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Monetary

Discussion Question

Most countries abandoned the strategy of monetary targeting when they realized that the link between

monetary aggregates and intermediate targets of monetary policy was not that strong anymore. There

seems to be some consensus about the fact that this happened due to the financial innovation process and

the inclusion of new regulations. Because these two factors will probably keep evolving, conclude by

discussing the future of the conduct of monetary policy.

Answer: Most policy makers agree that the process of financial innovation, fueled by the profit-seeking

D. For Information About Application: A Tale of Three Oil Price Shocks

Data Source

Bureau of Labor Statistics:

Bernanke, Ben S., “Outstanding Issues in the Analysis of Inflation”:

Discussion Question

As a response to the financial crisis of 2007–2009 the FOMC has lowered the federal funds target to close

to zero for around two years now. However, long-term inflation expectations remained low during this

Chapter 21 The Role of Expectations in Macroeconomic Policy 249

period. Conclude with a comment about the public’s confidence on the Federal Reserve’s ability and

willingness to fight inflation.

Answer: The fact that long-term inflation expectations did not increase (they remained mostly constant)

E. For Information About Policy and Practice: Ben Bernanke and the Federal

Reserve Adoption of Inflation Targeting

Data Source

Federal Reserve System, “FOMC statement”:

Bernanke, Ben S., “Inflation Targeting”:

Discussion Question

The transition from Greenspan’s chairmanship to Bernanke’s chairmanship was quite smooth. Conclude

with a discussion about the compatibility of the conduct of monetary policy with an implicit nominal

anchor and inflation targeting.

Answer: The fact that the transition from Greenspan to Bernanke was quite smooth (only a few extra

F. For Information About Policy and Practice: The Appointment of Paul

Volcker, Anti-Inflation Hawk

Data Source

Federal Reserve Bank of St. Louis database (FRED):

250 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Discussion Question

Suppose that after a long period of low and stable inflation but significant changes in output a new

chairman has to be nominated. Do you think that an inflation hawk has more or less chances of being

selected than an individual with a reputation of smoothing output fluctuations?

Answer: When a U.S. president has to nominate a Fed chairman, some of these questions arise. If inflation

decreasing inflation after a period of high inflation.