Central Bank Policy
What should the Fed do?
The Goals of Monetary Policy
• Price Stability
• High Employment
• Economic Growth
• Financial Market Stability
• Interest Rate Stability
• Exchange Rate Stability
Price Stability
• Implies keeping inflation both low and stable
• Increasingly viewed as the most important goal
of monetary policy
• The costs of inflation:
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Menu costs
Shoeleather costs
Increased uncertainty
Arbitrary redistributions of wealth
• Increasing evidence that high inflation actually
slows economic growth.
• Need to use a nominal anchor (monetary
aggregate or the inflation rate?)
High Employment
• High unemployment creates both personal and
societal costs
• With unemployment, there are idle resources
that could be put to work.
• What employment rate should the Fed target?
– Frictional Unemployment
– Structural Unemployment
– Natural Rate of Unemployment
• Tricky policy target, as the natural rate can
change over time.
• Better short run target than a long run one.
Economic Growth
• Promoting economic growth should lead to lower
unemployment and lower inflation in the long run
• Supply Side Economics:
– Give firms a greater incentive to invest and people a greater
incentive to save.
– Increased investment rates will expand the capital stock in the
future.
– Greater production will lead to both lower unemployment and
lower prices as returns trickle down throughout the economy
• Effective in theory, but may generate significant short-run
pain.
• How should monetary policy be used to promote growth?
Stability
• Financial Market Stability
– Bank panics and financial crises can create great strain on the
economy
– The Fed can help avert these crises by acting as a lender of last
resort and providing technical assistance to financial markets.
• Interest Rate Stability
– Volatile interest rates increase uncertainty and reduce both
savings and investment.
– Rapidly rising interest rates may create hostility toward the
Central Bank, leading to a loss of independence.
• Exchange Rate Stability
– International trade and investment is damaged by wildly
fluctuating exchange rates.
– Central bank intervention in foreign exchange markets can
temper these movements, increasing stability.
The Time Inconsistency of Monetary Policy
• Monetary policy is often crafted to produce a long-run outcome (like
price stability)
• However, the actions needed to achieve this long run goal may not
be the best choices in the short run.
• Such policies are time-inconsistent
– We do not consistently follow the plan over time. Such a plan will
almost always be abandoned.
• Suppose the Fed wanted to pursue the long run goal of price
stability
– In the short run, they will be tempted to inflate the economy to boost
economic output.
– Doing so jeopardizes the goal of long run price stability as people revise
their expectations about the Fed’s policy stance
– Expected inflation rises, which causes wages and prices to rise in the
long run!
Should Price Stability be the Primary Goal?
• In the long run, price stability and the other goals of
monetary policy are not mutually exclusive.
– The natural rate of unemployment is unaffected by inflation
– Economic growth is only affected by real variables in the long
run
– Price stability will promote interest rate and exchange rate
stability in the long run.
• However, short-run price stability will frequently conflict
with these other goals of monetary policy.
– Faced with rapidly rising prices, the Fed would have to cut the
money supply and raise interest rates
– Doing so increases short-run unemployment and creates
volatility in financial markets though!
Hierarchical vs. Dual Mandates
• Price stability is an important goal for monetary policy, but should it
take precedence over all others?
• In a hierarchical mandate, price stability is the first goal and any
other policy objective may only be targeted so long as it doesn’t
interfere with price stability.
– The ECB has a hierarchical mandate – it can pursue high levels of
employment and economic growth as long as it doesn’t endanger price
stability.
• In a dual mandate, the central bank can simultaneously pursue both
price stability and other goals (usually low unemployment). These
goals may conflict in the short run.
– The Fed operates under such a system, with the stated goals of
maximum employment, stable prices, and moderate long-term interest
rates.
– There is no stated order of preference amongst these goals.
Hierarchical vs. Dual Mandates
• A hierarchical mandate reinforces the public’s belief in the central
bank’s commitment to price stability.
• It gets around the time inconsistency problem by limiting the policies
that the central bank can do.
• However, it can lead to the central bank targeting short-run price
stability, leading to large fluctuations in output and employment.
• A dual mandate gives central banks the freedom to stabilize
employment in the short run while still setting a long run policy target
of price stability.
• However, the dual mandate is subject to the time inconsistency
problem.
• If people believe that the central bank is always going to promote
employment over price stability in the short run, they will revise their
inflation expectations upward.
Monetary Targeting
• To achieve price stability, you need to have some benchmark that
tells you how stable prices are.
• Two such targets are widely used: monetary aggregates and the
inflation rate.
• In monetary targeting, the central bank announces that it will target
an annual growth rate in a particular monetary aggregate (like M1 or
M2).
• Once the rate is set, the Central Bank is responsible for hitting this
target
• This policy is transparent, flexible and accountable.
• It sends a strong signal of the Central Bank’s policy objective and
inflation expectations should adjust.
• However, it does require that the target (M1 for example) and the
goal variable (inflation) have a strong relationship.
Inflation Targeting
• The biggest weakness of monetary targeting is that there may not
be a strong relationship between the monetary target and inflation.
• So why not directly target inflation?
• With inflation target, the central bank makes a public announcement
of the inflation target.
– This is an attempt to revise inflation expectations
• Then the central bank makes an institutional commitment to price
stability (and the inflation target) as a long-run goal.
• Policy decisions (to hit the inflation target) are made using as much
information as is available
• The process by which the central bank reached a policy is made
transparent through open communication with the public
• If the central bank fails to hit its objective, it is held accountable.
Inflation Targeting
• Inflation targeting has been successfully used to achieve long-run
price stability in Canada, New Zealand, and the UK.
• However, the process by which long-run stability was achieve
involved significant short-term pain.
• Advantages
– Does not rely on one variable to achieve the target
– Transparent and policymakers are accountable for their actions.
– Better insulated from time-inconsistency problem.
• Disadvantages
– Delayed signaling  inflation rates are known ex-post,
oftentimes with long lags. Need to know current rate to know the
stance of the central bank’s target.
– Too inflexible, potentially leading to disruptive output fluctuations
– During the transition period, there is low economic growth 
how long until we reach the long run?
Inflation Targeting in Canada and New Zealand
Forward Looking Monetary Policy
• For countries with a long history of stable prices, there is significant
inertia in prices.
– The effects of monetary policy may not be felt for up to one year on
output and two years on prices.
– These lag times are shorter for countries with a history of more volatile
inflation (prices are necessarily more flexible)
• Because monetary policy takes so long to have an impact, it cannot
be reactive.
• Rather, the central bank needs to take pre-emptive actions.
– If the Fed thinks inflation is going to rise in two years, it needs to raise
interest rates today
– If the Fed thinks unemployment is going to rise next year, it needs to
increase the money supply today.
• Because of these lag times, perhaps the best monetary policy target
is an “implicit nominal anchor” that is adaptable to the needs of the
economy.
Implicit Nominal Anchors
• Advantages
– Forward looking and pre-emptive
– Uses multiple sources of information to make decisions
– Forward-looking policy helps to overcome time-inconsistency
problem
– Has a proven track record of success in the U.S.
• Disadvantages
– Lack of transparency and accountability
– Depends on the abilities and trustworthiness of the people
making monetary policy  policymakers change!
– Undemocratic?
Reviewing Monetary Policy Strategies
Choosing a Policy Instrument
• In conducting monetary policy, the central bank has
several policy instruments through which it hopes to
achieve its policy goal
– In many cases, it uses to policy instrument to achieve an
intermediate target which is related to the policy goal.
– Ex: The Fed wants to achieve an inflation rate of 3% (policy
goal), so it targets the growth rate in M1 (intermediate target) to
be 2%. To get this M1 growth rate, the Fed changes NonBorrowed Reserves (the policy instrument) through Open Market
Operations.
• The two most commonly used policy instruments are
monetary aggregates like NBR and interest rates like the
federal funds rate.
• The central bank can directly control one of these
instruments, but not both simultaneously.
Using NBR as a Policy Instrument cedes
Control over the Federal Funds Rate
Using the Federal Funds Rate as a Policy
Instrument cedes control over NBR
Choosing a Policy Instrument
• The Policy Instrument should be Observable and
Measurable
– Quick observation and measurement are necessary to signal the
central bank’s policy stance
– NBR take up to two weeks to report compared to iff, which is
available immediately (though rff is subject to expected inflation)
• It should be Controllable
– The ability of the central bank to conduct policy rests on its ability
to change the policy instrument
• It should produce Predictable Outcomes
– If the policy instrument is changed, how accurately can we
predict its effect on the policy goal?
The Taylor Rule
• So how should the Fed behave?
– Most economists argue that the Fed should have a policy goal of
long run price stability
– If credible, a dual mandate allows the Fed to moderate short run
output fluctuations
– The policy instrument should be the Federal Funds rate
• The economist John Taylor devised a “rule” for the Fed
to follow that tracks the above recommendation:
– iff* = π + rff* + α*(π-π*) + β*(y-y*)
– The Fed should set the federal funds rate based on the current
rate of inflation, the equilibrium real federal funds rate (that which
would exist at full employment), and a weighted average of the
inflation gap (the difference between current and desired
inflation) and the output gap (the percentage difference between
actual and full employment output).
The Taylor Rule in Practice
rff* = 2%, π* = 2%, α = β = 0.5