TheEconomicsofMoney,Banking,andFinancialMarketsThirteenthEditionChapter16TheConductofMonetaryPolicy:StrategyandTacticsCopyright?2022,2019,2016PearsonEducation,Inc.AllRightsReservedPreviewThischapterexaminesthegoalsofmonetarypolicyandthenconsidersoneofthemostimportantstrategiesfortheconductofmonetarypolicy,inflationtargetingLearningObjectives(1of2)16.1Defineandrecognizetheimportanceofanominalanchor.16.2Identifythesixpotentialgoalsthatmonetarypolicymakersmaypursue.16.3Summarizethedistinctionsbetweenhierarchicalanddualmandates.16.4Compareandcontrasttheadvantagesanddisadvantagesofinflationtargeting.16.5IdentifythekeychangesmadeovertimetotheFederalReservemonetarypolicystrategy.LearningObjectives(2of2)16.6Listthefourlessonslearnedfromtheglobalfinancialcrisisanddiscusswhattheymeantoinflationtargeting.16.7Summarizetheargumentsforandagainstcentralbankpolicyresponsetoasset-pricebubbles.16.8Describeandassessthefourcriteriaforchoosingapolicyinstrument.16.9InterpretandassesstheperformanceoftheTaylorruleasahypotheticalpolicyinstrumentforsettingthefederalfundsrate.ThePriceStabilityGoalandtheNominalAnchorOverthepastfewdecades,policymakersthroughouttheworldhavebecomeincreasinglyawareofthesocialandeconomiccostsofinflationandmoreconcernedwithmaintainingastablepricelevelasagoalofeconomicpolicy.Theroleofanominalanchor:

anominalvariable,suchastheinflationrateorthemoneysupply,whichtiesdownthepriceleveltoachievepricestabilityThetime-inconsistencyproblemOtherGoalsofMonetaryPolicyFiveothergoalsarecontinuallymentionedbycentralbankofficialswhentheydiscusstheobjectivesofmonetarypolicy:HighemploymentandoutputstabilityEconomicgrowthStabilityoffinancialmarketsInterest-ratestabilityStabilityinforeignexchangemarketsShouldPriceStabilityBethePrimaryGoalofMonetaryPolicy?HierarchicalversusDualMandates:Hierarchicalmandatesputthegoalofpricestabilityfirst,andthensaythataslongasitisachievedothergoalscanbepursuedDualmandatesareaimedtoachievetwocoequalobjectives:pricestabilityandmaximumemployment(outputstability)PriceStabilityasthePrimary,Long-RunGoalofMonetaryPolicyEithertypeofmandateisacceptableaslongasit

operatestomakepricestabilitytheprimarygoalinthelongrunbutnottheshortrun.InflationTargeting

(1of3)Publicannouncementofmedium-termnumericaltargetforinflationInstitutionalcommitmenttopricestabilityastheprimary,long-rungoalofmonetarypolicyandacommitmenttoachievetheinflationgoalInformation-inclusiveapproachinwhichmanyvariablesareusedinmakingdecisionsIncreasedtransparencyofthestrategyIncreasedaccountabilityofthecentralbankInflationTargeting

(2of3)NewZealand(effectivein1990)Inflationwasbroughtdownandremainedwithinthetargetmostofthetime.Growthhasgenerallybeenhigh,andunemploymenthascomedownsignificantly.Canada(1991)Inflationdecreasedsince1991;somecostsintermofunemploymentUnitedKingdom(1992)Inflationhasbeenclosetoitstarget.Growthhasbeenstrong,andunemploymenthasbeendecreasing.Figure1InflationRatesandInflationTargetsforNewZealand,Canada,andtheUnitedKingdom,1980–2020Sources:BenS.Bernanke,ThomasLaubach,FredericS.Mishkin,andAdamS.Poson,InflationTargeting:LessonsfromtheInternationalExperience

(Princeton,N

J:PrincetonUniversityPress,1999);andFederalReserveBankofSt.LouisF

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Ddatabase:https:///series/NZLCPIALLQINMEI

;https:///series/CPALCY01CAA661N

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.InflationTargeting

(3of3)Advantages:Reducespotentialoffallingintime-inconsistencytrapEasilyunderstoodStressestransparencyandaccountabilityConsistencywithdemocraticprinciplesImprovedperfomanceDisadvantages:DelayedsignalingToomuchrigidityPotentialforincreasedoutputfluctuationsLoweconomicgrowthduringdisinflationTheEvolutionoftheFederalReserve’sMonetaryPolicyStrategy

(1of2)TheUnitedStateshasachievedexcellentmacroeconomicperformance(includinglowandstableinflation)untiltheonsetoftheglobalfinancialcrisiswithoutusinganexplicitnominalanchorsuchasaninflationtarget.History:Fedbegantoannouncepubliclytargetsformoneysupplygrowthin1975PaulVolker(1979)focusedmoreinnon-borrowedreservesGreenspanannouncedinJuly1993thattheFedwouldnotuseanymonetaryaggregatesasaguideforconductingmonetarypolicyTheEvolutionoftheFederalReserve’sMonetaryPolicyStrategy

(2of2)ThereisnoexplicitnominalanchorintheformofanoverridingconcernfortheFed.Forwardlookingbehaviorandperiodic“preemptivestrikes”Thegoalistopreventinflationfromgettingstarted.AdvantagesUsesmanysourcesofinformationDemonstratedsuccessDisadvantagesLackofaccountabilityInconsistentwithdemocraticprinciplesTheFed’s“JustDoIt”MonetaryPolicyStrategyAdvantagesoftheFed’s“JustDoIt”Approach:

forward-lookingbehaviorandstressonpricestabilityalsohelptodiscourageoverlyexpansionarymonetarypolicy,therebyamelioratingthetime-inconsistencyproblemDisadvantagesoftheFed’s“JustDoIt”Approach:lackoftransparency;strongdependenceonthepreferences,skills,andtrustworthinessoftheindividualsinchargeofthecentralbankTheEvolutionoftheFederalReserve’sMonetaryPolicyStrategyAdvantagesUsesmanysourcesofinformationDemonstratedsuccessDisadvantagesLackofaccountabilityInconsistentwithdemocraticprinciplesInsidetheFed:BenBernanke’sAdvocacyofInflationTargetingWhileaprofessoratPrinceton,Bernanke,inseveralarticlesandinabookcowrittenwiththeauthorofthisbook,arguedthatinflationtargetingwouldbeamajorstepforwardfortheFederalReserveandwouldproducebettereconomicoutcomes,formanyofthereasonsoutlinedearlier.WhenBernanketookhispositionasagovernoroftheFederalReservefrom2002to2005,hecontinuedtoadvocatetheadoptionofaninflationtarget.Global:TheEuropeanCentralBank’sMonetaryPolicyStrategyTheEuropeanCentralBank(E

C

B)hasalsobeenslowtomovetowardinflationtargeting,adoptingahybridmonetarystrategythatincludessomeelementsofinflationtargeting.LessonsforMonetaryPolicyStrategyfromtheGlobalFinancialCrisisDevelopmentsinthefinancialsectorhaveafargreaterimpactoneconomicactivitythanwasearlierrealized.Thezero-lower-boundoninterestratescanbeaseriousproblem.Thecostofcleaningupafterafinancialcrisisisveryhigh.Priceandoutputstabilitydonotensurefinancialstability.ImplicationsforInflationTargetingLeveloftheInflationTargetFlexibilityofInflationTargetingInsidetheFed:TheFed’sNewMonetaryPolicyStrategy:AverageInflationTargetingInAugust2020,theFederalReserveannouncedthatitwouldnowtargetanaverageinflationrateof2%.Pastinflationrates,asaresult,wouldnowaffectitstargetintheshortrun.ShouldCentralBanksRespondtoBubbles?HowshouldCentralbanksrespondtoassetpricebubbles?Asset-pricebubble:pronouncedincreaseinassetpricesthatdepartfromfundamentalvalues,whicheventuallyburst.Typesofasset-pricebubblesCredit-drivenbubblesSubprimefinancialcrisisBubblesdrivenbyirrationalexuberanceShouldCentralBanksRespondtoBubbles?(1of2)The“Greenspandoctrine”:monetarypolicyshouldnotbeusedtoprickbubbles.asset-pricebubblesarenearlyimpossibletoidentifyraisinginterestratesmaybeveryineffectiveinlimitingbubblesbecausemarketparticipantsexpectsuchhighratesofreturnfrombuyingbubble-drivenassetsmonetarypolicyactionsareabluntinstrumentandlikelytoaffectassetpricesingeneral,ratherthanthespecificassetsthatareexperiencingabubblemonetarypolicyactionstoprickbubblescanhaveharmfuleffectsontheaggregateeconomy.timelymonetarypolicycankeeptheharmfuleffectsofaburstingbubblecanbekeptatamanageablelevelShouldCentralBanksRespondtoBubbles?(2of2)Macropudentialpolicy:regulatorypolicytoaffectwhatishappeningincreditmarketsintheaggregate.Monetarypolicy:Centralbanksandotherregulatorsshouldnothavealaissez-faireattitudeandletcredit-drivenbubblesproceedwithoutanyreaction.Tactics:ChoosingthePolicyInstrumentToolsOpenmarketoperationReserverequirementsDiscountratePolicyinstrument(operatinginstrument)ReserveaggregatesInterestratesMaybelinkedtoanintermediatetargetInterestrateandaggregatetargetsareincompatible(mustchooseoneortheother).Figure2LinkagesAmongCentralBankTools,PolicyInstruments,IntermediateTargets,andGoalsofMonetaryPolicyFigure3ResultofTargetingonNonborrowedReservesFigure4ResultofTargetingontheFederalFundsRateCriteriaforChoosingthePolicyInstrumentObservabilityandMeasurabilityControllabilityPredictableeffectonGoalsTactics:TheTaylorRuleAninflationgapandanoutputgapStabilizingrealoutputisanimportantconcernOutputgapisanindicatoroffutureinflationasshownbyPhillipscurveN

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URateofunemploymentatwhichthereisnotendencyforinflationtochangeFigure