CHAPTER 25. 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. Ultimately, this decision depends on the degree to which the central bank cares about
fluctuations in unemployment and inflation. Operationally, central bankers now think about monetary
policy in terms of a desired interest rate, rather than a desired rate of money growth, in large part because
monetary aggregates have proven not to have a close relationship to inflation.
II.
WHY THE ANSWER MATTERS
Whether the central bank should target interest rates is the preeminent macroeconomic policy issue. This
chapter provides a basis for thinking about this question in light of the long-run objectives of the central
bank. The United States is apparently in a golden era of monetary policymaking, often attributed to the
talents of Alan Greenspan. Does the success of the Fed (or any central bank) depend upon the
intelligence and luck of its leader, or can monetary policymaking be reduced to some relatively simple
guidelines?
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
The chapter introduces monetary aggregates. M1 (which was mentioned briefly in Chapter 4) is
the sum of currency and checkable deposits. M2 is the sum of M1, money market mutual fund shares,
money market deposit accounts, and small time deposits (CDs less than $100,000 denomination).
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 the organization of the U.S. Federal Reserve System.
IV. SUMMARY OF THE MATERIAL
The analysis in previous chapters suggests that monetary policy has different effects in the short run, the
medium run, the and long run run. 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.
1.
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. At very high rates of inflation, money performs all of its
functions badly because its purchasing power changes often. It is also a poor unit of account because
prices change so frequently. And because more money is required for transactions, it is a poor medium
of exchange. Finally, it is a poor store of value because its purchasing power drops continuously. . At
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low inflation rates, the costs of inflation are harder to identify. Economists emphasize four sources of
cost.
i. Higher nominal interest rates cause people to economize on holdings of money. This effort
requires resources, referred to with the quaint expression “shoe leather costs.” Such costs can
become quite large during hyperinflation, but are unlikely to be very important when inflation
is low.
ii. When the tax system is not indexed, the tax burden will depend on the rate of inflation. In
the United States, this issue applies mainly 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 has addressed some of these issues.
iii. 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. (Of
course this must be true to a certain extent. People don’t know the true current inflation rate.
They only know what inflation was last month.) Thus, inflation leads people and firms to make
incorrect decisions.
iv. 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. However using the
information they provide is made more difficult by the fact that the Treasury seems determined
to issue indexed bonds with odd maturities that don’t line up very well with the maturities of
nominal bonds.
Inflation also has three benefits.
i. Seignorage—the amount of resources the government collects by printing money—increases
at higher rates of inflation, at least over some initial range. However, 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.
ii. Since nominal interest rates 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 stimulate output during recession.
iii. Money illusion may cause workers to resist nominal wage cuts, independent of the effects
on the real wage. As a result, ongoing inflation will cut real wages faster than waiting for the
nominal wage to adjust.
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 are avoided by indexing the tax system and issuing more
indexed bonds. In addition, there are benefits to maintaining some inflation, and the cost of achieving
zero inflation (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
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monetary policy. Note, however, that zero inflation would necessarily remain a target. Statistically it
would be impossible to achieve exactly zero inflation on a month-to-month basis.
2.
The Design of Monetary Policy
Until the 1990s, central bankers typically conceived monetary policy in terms of the rate of money
growth. Central banks chose a rate of money growth that corresponded to their inflation target, and
worried about how closely the growth of monetary aggregates matched their goals. However, 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 conceive monetary policy in terms of the nominal interest rate.
They try to achieve their 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 saw a recession arising from an adverse demand curve,
it would know that inflation would fall. Thus, it would pursue a monetary expansion to increase
inflation. Indeed, if inflation is constant, 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 usually 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 other events could justify changing the nominal interest rate for reasons not
included in the rule. However, 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. (Taylor notes the central bankers probably did not think of setting
their targets this way during their policy debates.) 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. That
could, of course, change if economic conditions warrant.
3.
The Fed in Action
The Humphrey-Hawkins Bill (which expired in mid-2000) charged the Federal Reserve to promote both
stable prices and maximum employment. Compared to most other central banks around the world, the
Fed has a substantial amount of political independence. Its organization consists of three parts.
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i. Twelve Federal Reserve Districts, with a District Federal Reserve Bank in each.
ii. The Board of Governors, consisting of seven members, including the chairman, who are
appointed by the President (and approved by the Senate) for 14-year terms. The chairman is
appointed by the President from this group, and has a renewable term of 4 years.
iii. The Federal Open Market Committee, consisting of twelve voting members—the seven
governors and five of the Reserve Bank presidents. (All twelve district bank presidents attend
each FOMC meeting and participate in the discussion. However only five of them actually
vote on policy. Four of the votes rotate among eleven bank presidents; the New York bank
president always votes.) This committee meets every six weeks and issues instructions to the
Open Market Desk, which is in charge of open market operations—the purchase and sale of
government bonds—at the New York Fed.
In addition to open market operations, the Fed has two other policy instruments: changes in reserve
requirements (the minimum fraction of checkable deposits banks must hold as reserves) and changes in
the discount rate. Since the banking system typically holds only the minimum required reserves, changes
in reserve requirements have drastic effects on bank balance sheets. As a result, the Fed hardly ever uses
changes in reserve requirements as a policy instrument. The discount rate is the rate at which banks can
borrow from the Fed. Changes in the discount rate were once the primary instrument of Fed policy.
Today, however, the Fed relies primarily on open market operations. Under the Fed’s new discount
window policy (announced in about 2001) banks can maintain something very similar to a line of credit
with the Fed. This “primary credit” can be tapped at will, but the interest rate is above the federal funds
rate.
As far as the actual behavior of the Federal Reserve, most economists believe that the monetary policy
record under Alan Greenspan—the chairman of the Fed since 1987—has been superb. Greenspan has
convinced financial market participants of his commitment to low inflation, but has also been willing to
use interest rates aggressively to stimulate the economy when necessary. Greenspan has never
announced an inflation target or any policy rule, interest rate or otherwise, that guides the behavior of the
Fed. However, the evidence suggests that the Fed has an implicit inflation target of about 2 to 3%, and
that it responds both to inflation and to deviations of unemployment from the natural rate, as would be
consistent with a Taylor rule. Although Greenspan's record is strong, some economists worry that
monetary policy depends too much on the Fed chairman. They would prefer that the Fed shift to explicit
inflation targeting and explicit discussion of interest rate rules.
V. PEDAGOGY
Some instructors may prefer to teach this chapter in reverse, starting from the institutional makeup of the
United States Federal Reserve System, proceeding from there to problems of short-run monetary policymaking, 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 should 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. Finally, the
discussion of the optimal rate of inflation could be incorporated into the discussion of disinflation in
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Chapter 9. As it stands, Chapter 9 discusses the unemployment costs of disinflation. Taking up the
optimal rate of inflation in that context would facilitate a discussion of why a society might be willing to
incur such costs.
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