Chapter 25. Monetary Policy: A Summing Up

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Monetary Policy:
A Summing Up
CHAPTER 25
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
25-1 The Optimal Inflation Rate
Chapter 25: Monetary Policy: A Summing Up
Table 25-1
Inflation Rates in OECD Countries since 1981
Year
1981
1985
1990
1995
2000
2006
OECD average*
10.5%
6.6%
6.2%
5.2%
2.8%
2.2%
Number of countries with
inflation below 5%†
2
10
15
21
24
25
* Average of GDP deflator inflation rates, using relative GDPs measured at PPP prices as weights.
Inflation has steadily gone down in rich countries
since the early 1980s.
The attempt to reduce it even further depends on
the costs and benefits of inflation.
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Monetary Policy: What You Have
Learned and Where
Chapter 25: Monetary Policy: A Summing Up
A quick review of Chapters 4 through 24 and
an overview of the information presented in
Chapter 25.
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25-1 The Optimal Inflation Rate
The Costs of Inflation
Chapter 25: Monetary Policy: A Summing Up
We’ve seen how very high inflation can disrupt economic activity.
The debate in OECD countries today, however, centers on the
advantages of, say, 0% versus 3% inflation a year. Within that
range, economists identify four main costs of inflation:
(1) shoe-leather costs,
(1) tax distortions,
(1) money illusion, and
(1) inflation variability.
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25-1 The Optimal Inflation Rate
The Costs of Inflation
Chapter 25: Monetary Policy: A Summing Up
Shoe-leather Costs
Shoe-leather costs are the costs of making more
trips to the bank in the presence of inflation. They
reflect an increase in the opportunity cost of
holding money.
Tax Distortions
Tax distortions occur when tax rates do not increase
automatically with inflation, a concept known as bracket
creep. Income for purposes of taxation includes nominal
interest payments, not real interest payments.
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25-1 The Optimal Inflation Rate
The Costs of Inflation
Chapter 25: Monetary Policy: A Summing Up
Money Illusion
Money illusion is the cost of inflation associated with the
notion that people make systematic mistakes in assessing
nominal versus real changes, leading people to make
incorrect decisions.
Inflation Variability
Inflation variability means that financial assets such as
bonds, which promise fixed nominal payments in the
future, become riskier.
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Money Illusion
Chapter 25: Monetary Policy: A Summing Up
There is a lot of anecdotal evidence that many people
fail to adjust properly for inflation in their financial
computations.
Recently, economists and psychologists have started
looking at money illusion more closely. In a recent
study, two psychologists, Eldar Shafir from Princeton
and Amos Tversky from Stanford, and one economist,
Peter Diamond from MIT, designed a survey aimed at
finding how prevalent money illusion is and what
causes it.
After conducting the study, it is suggested that money
illusion is very prevalent and that people have a hard
time adjusting for inflation.
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25-1 The Optimal Inflation Rate
The Benefits of Inflation
Inflation is actually not all bad. One can identify three benefits
of inflation:
Chapter 25: Monetary Policy: A Summing Up
(1) seignorage,
(2) the option of negative real interest rates for
macroeconomic policy, and
(3) the use of the interaction between money illusion and
inflation in facilitating real wage adjustments.
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25-1 The Optimal Inflation Rate
The Benefits of Inflation
Seignorage
Chapter 25: Monetary Policy: A Summing Up
Seignorage, or the revenues from money creation, allow
the government to borrow less from the public, or to
lower taxes.
An economy with a higher average inflation rate has
more scope to use monetary policy to fight a recession.
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25-1 The Optimal Inflation Rate
The Benefits of Inflation
Chapter 25: Monetary Policy: A Summing Up
The Option of Negative Real Interest Rates
In short, an economy with a higher average inflation
rate has more scope to use monetary policy to fight a
recession. An economy with a low average inflation
rate may find itself unable to use monetary policy to
return output to a natural level of output.
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25-1 The Optimal Inflation Rate
The Benefits of Inflation
Money Illusion Revisited
Chapter 25: Monetary Policy: A Summing Up
Paradoxically, the presence of money illusion provides at
least one argument for having a positive inflation rate.
The presence of inflation allows for downward real-wage
adjustments more easily than when there is no inflation.
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25-1 The Optimal Inflation Rate
The Optimal Inflation Rate: The Current Debate
Chapter 25: Monetary Policy: A Summing Up
Those who aim for small but positive inflation argue that
some of the costs of positive inflation can be avoided, and
the benefits are worth keeping.
Those who aim for zero inflation argue that this amounts to
price stability, which simplifies decisions and eliminates
money illusion.
Today, most central banks appear to be aiming for a low but
positive inflation, between 2 and 3%.
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25-2 The Design of Monetary Policy
Chapter 25: Monetary Policy: A Summing Up
Most central banks have adopted an inflation rate
target rather than a nominal money growth rate
target. And, they think about short-run monetary
policy in terms of movements in the nominal interest
rate rather than in terms of movements in the rate of
nominal money growth.
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25-2 The Design of Monetary Policy
Money Growth Targets and Target Ranges
Chapter 25: Monetary Policy: A Summing Up
Until the 1990s, monetary policy, in the US and other
OECD countries, was typically conducted as follows:
 The central bank chose a target rate for nominal
money growth corresponding to the inflation rate
it wanted to achieve in the medium run.
 In the short run, the central bank allowed for
deviations of nominal money growth from the target.
 To communicate to the public both what it wanted to
achieve in the medium run and what it intended to do
in the short run, the central bank announced a range
for the rate of nominal money growth.
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25-2 The Design of Monetary Policy
Money Growth and Inflation Revisited
Figure 25 – 1
Chapter 25: Monetary Policy: A Summing Up
M1 Growth and Inflation:
10-Year Averages since
1970
There is no tight relation between M1 growth and inflation—not
even in the medium run.
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25-2 The Design of Monetary Policy
Money Growth and Inflation Revisited
Chapter 25: Monetary Policy: A Summing Up
The relation between M1 growth and inflation is not
tighter because of shifts in the demand for money.
When people reduce their bank account balances and
move to money market funds, there is a negative shift
in the demand for money.
Frequent and large shifts in money demand created
serious problems for central banks.
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25-2 The Design of Monetary Policy
Inflation Targeting
Chapter 25: Monetary Policy: A Summing Up
In many countries, central banks have defined as their
primary goal the achievement of a low inflation rate, both in
the short run and in the medium run. This is known as
inflation targeting.
 Trying to achieve a given inflation target in the medium
run would seem a clear improvement over trying to
achieve a nominal money growth target.
 Trying to achieve a given inflation target in the short run
would appear to be much more controversial.
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The Unsuccessful Search for the Right
Monetary Aggregate
Chapter 25: Monetary Policy: A Summing Up
Measures that include not only money but other liquid
assets are called monetary aggregates, under the name
of M2, M3, and so on.
In the United States, M2 is also called broad money.
The central bank could choose M2 growth as target,
however the relation between M2 growth and inflation is
not very tight either, and the central bank does not control
M2. Many financial assets are very liquid (financial assets
that can be exchanged for money at little cost), which
makes them attractive as substitutes for money. However,
these assets are not included in M1.
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Chapter 25: Monetary Policy: A Summing Up
The Unsuccessful Search for the Right
Monetary Aggregate
Figure 1 M2 Growth and Inflation: 10-Year Averages since 1970
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25-2 The Design of Monetary Policy
Inflation Targeting
Chapter 25: Monetary Policy: A Summing Up
The result that we have just derived – that inflation
targeting eliminates deviations of output from its
natural level – is too strong, however, for two reasons:
 The central bank cannot always achieve the rate
of inflation it wants in the short run.
 Like all other macroeconomic relations, the
Phillips curve relation does not hold exactly.
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25-2 The Design of Monetary Policy
Interest Rate Rules
Chapter 25: Monetary Policy: A Summing Up
According to the Taylor rule, since it is the interest
rate that directly affects spending, the central bank
should choose an interest rate rather than a rate of
nominal money growth.
it  i *  a( t   *) b(ut  un )
Taylor’s rule provides a way of thinking about
monetary policy: Once the central bank has chosen a
target rate of inflation, it should try to achieve it by
adjusting the nominal interest rate.
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25-2 The Design of Monetary Policy
Interest Rate Rules
it  i *  a( t   e )  b(ut  un )
Chapter 25: Monetary Policy: A Summing Up
 If  t   *, and ut  un , then the central bank should set it
equal to its target value, i*.
 If inflation is higher than the target ( t   *) , the central
bank should increase the nominal interest rate it above i*.
 If unemployment is higher than the natural rate of
unemployment (u>un), the central bank should decrease
the nominal interest rate.
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25-2 The Design of Monetary Policy
Interest Rate Rules
Chapter 25: Monetary Policy: A Summing Up
Since it was first introduced, the Taylor rule has generated a lot of
interest, both from researchers and from central banks:
 Researchers looking at the behavior of both the Fed in the
US and the Bundesbank in Germany have found the rule
describes their behavior over the last 15-20 years.
 Other researchers have explored whether it is possible to
improve on this simple rule.
 Yet other researchers have discussed whether central banks
should adopt an explicit interest rate rule and follow it closely.
 In general, most central banks have now shifted to thinking in
terms of an interest rate rule.
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25-3 The Fed in Action
The Mandate of the Fed
Chapter 25: Monetary Policy: A Summing Up
The mandate of the Federal Reserve System was
most recently defined in the Humphrey-Hawkins
Act, passed by Congress in 1978.
For more information on how the Fed is organized, go
to the Fed’s Web site:
www.federalreserve.gov/
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25-3 The Fed in Action
The Organization of the Fed
The Federal Reserve System is composed of three parts:
 A set of 12 Federal Reserve Districts
Chapter 25: Monetary Policy: A Summing Up
 The Board of Governors
 The Federal Open Market Committee (FOMC)
and the Open Market Desk.
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25-3 The Fed in Action
The Instruments of Monetary Policy
H  [c   (1  c)]$YL(i )
Chapter 25: Monetary Policy: A Summing Up
The equilibrium interest rate is the interest rate at which the
supply (left side) and the demand (right side) for central
bank money are equal.
The money supply, H, refers to the monetary base. The
demand for money is the sum of the demand for currency
and the demand for reserves by banks (refer to chapter 4
for more detail).
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25-3 The Fed in Action
The Instruments of Monetary Policy
Reserve Requirements
Chapter 25: Monetary Policy: A Summing Up
Reserve requirements are the minimum amount of
reserves that banks must hold in proportion to checkable
deposits.
By changing reserve requirements, the Fed effectively
changes the demand for central bank money.
This instrument of monetary policy is not widely used
because banks may take drastic actions to increase their
reserves, such as recalling some of the loans.
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25-3 The Fed in Action
The Instruments of Monetary Policy
Lending to Banks
Chapter 25: Monetary Policy: A Summing Up
The Fed can also lend to banks, thereby affecting the
supply of central bank money.
The set of conditions under which the Fed lends to banks
is called discount policy. The Fed lends at a rate called
the discount rate, through the discount window.
Today, changes in the discount rate are used mostly as a
signal to financial markets.
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25-3 The Fed in Action
The Instruments of Monetary Policy
Chapter 25: Monetary Policy: A Summing Up
Open Market Operations
Open-market operations, the purchase and sale of
government bonds in the open market, is the main
instrument of U.S. monetary policy. It is convenient
and flexible.
When the Fed buys bonds, it pays for them by
creating money, thereby increasing the money
supply, H. When it sells bonds, it decreases H.
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25-3 The Fed in Action
The Implementation of Policy
Chapter 25: Monetary Policy: A Summing Up
The most important monetary policy decisions are made
at meetings of the FOMC.
Fed staff prepares forecasts and simulations of the
effects of different monetary policies on the economy,
and identifies the major sources of uncertainty.
The conduct of open-market operations between FOMC
meetings is left to the Open Market Desk.
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25-3 The Fed in Action
The Implementation of Policy
Chapter 25: Monetary Policy: A Summing Up
Does the Fed have an inflation target, or follow an interest
rate rule?
 The answer is: we don’t know. Alan Greenspan, the
chairman of the Fed until 2006, never specifically
stated an inflation target, nor has his successor, Ben
Bernanke.
 The evidence strongly shows that the Fed has in fact
an implicit inflation target of about 2-3%. It is also
clear that the Fed adjusts the federal funds rate in
response both to the inflation rate and to deviations of
unemployment from the natural rate.
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25-3 The Fed in Action
The Implementation of Policy
Chapter 25: Monetary Policy: A Summing Up
Does it matter that the Fed has neither an explicit
inflation target nor an explicit interest rate rule?
 Many economists say: Do not argue with success.
The record of monetary policy under both Alan
Greenspan and Ben Bernanke has been
outstanding.
 Other economists are more skeptical. They argue
that it is unwise to have monetary policy depend so
much on one individual, that the next Chairman of
the Fed may not be able to achieve the same mix of
credibility and flexibility.
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25-3 The Fed in Action
The Implementation of Policy
Figure 25 – 2
Chapter 25: Monetary Policy: A Summing Up
The Federal Funds Rate
since 1987
In 1990–1991, and again in 2001, the Fed dramatically decreased
the federal funds rate to reduce the depth and length of the
recession.
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Chapter 25: Monetary Policy: A Summing Up
Key Terms








shoe-leather costs
money illusion
inflation targeting
liquid asset
monetary aggregates,
broad money (M2)
Taylor rule
Humphrey-Hawkins Act
 Federal Reserve Districts
 Board of Governors
 Federal Open Market
Committee (FOMC)
 Open Market Desk
 reserve requirements
 discount policy
 discount rate
 discount window
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