Chapter 16: Conduct of Monetary Policy Flashcards
price stability
low and stable inflation
hyperinflation
unstable prices that are damaging to the economy
nominal anchor
a nominal variable that ties down the price level to achieve price stability
ex. inflation rate or money supply
time inconsistency problem
monetary policy conducted on a discretionary day-to-day basis that leads to poor long term outcomes
five goals of central banks apart from price stability
- high employment and output stability
- economic growth
- stability of financial markets
- interest rate stability
- stability in foreign exchange markets
why is high employment important
- unemployment causes human misery
- unemployment causes idle workers and idle resources
frictional unemployment
searches by workers and firms to find suitable matchups
structural unemployment
a mismatch between job requirements and the skills of availability of local workers
natural rate of unemployment
a level above zero that is consistent with full employment where demand for labor equals supply of labor
natural rate of output/potential output
a particular level of output produced at the natural rate of unemployment
supply side economics
spur economic growth by providing tax incentives for business to invest in facilities and equipment and for taxpayers to save more
why is interest rate stability important
fluctuations in interest rate can create uncertainty
why is stability in Foreign Exchange Markets important?
makes it easier for firms and individuals to purchase or sell goods abroad to plan ahead
hierarchical mandates
putting the goal of price stability first and then pursue other goals after price stability is achieved
- price stability should only be a long-term goal
dual mandate
achieve price stability and maximum employment together
- might lead to overly expansionary policies
inflation targeting
recognition that price stability should be a primary long-term goal and a nominal anchor can help goal
elements of inflation targeting
- public announcement of medium-term numerical objectives for inflation
- an institutional commitment to price stability as the primary, long run goal and a commitment to achieving the inflation goal
- an information inclusive approach where many variables are used to make decisions about monetary policy
- increased transparency of monetary policy objectives
- increased accountability of the central bank
advantages of inflation targeting
- reduction of time-inconsistency problem
- increased transparency
- increased accountability
- consistency with Democratic Principles
- Improved performance
disadvantages of inflation targeting
- delayed signaling
- too much rigidity
- potential for increased output fluctuations
- low economic growth
four basic lessons for economists and policymakers on how the economy works
- developments in the financial sector have a greater impact on economic activity
- zero lower bound on interest rates can be a problem
- the cost of cleaning up after financial crises is high
- price and output stability do not ensure financn
asset-price bubbles
pronounced increases in asset prices
Types of asset-price bubbles
- one type driven by credit
- second type drive by overly optimistic expectations
credit-driven bubbles
credit boom causes bubble
- more lending, increases price
- people can’t pay, creates less lending, decreases prices
overly optimistic expectations (irrational exuberance) bubbles
less dangerous than credit-driven bubbles
Pro central banks popping bubbles
specially for credit-driven bubbles
- costly and difficult to clean up
Con central banks popping bubbles
- bubbles are hard to identify
- interest rates may be ineffective in restraining bubbles
- a bubble may be present in only a fraction of asset markets
- can have harmful effects on aggregate economy
- harmful effects of bubbles can be kept at a manageable level
macroprudential regulation
supervision and regulations on credit risks
what can be used to restrain bubbles?
- macroprudential regulation
- monetary policies
policy instrument/operating instrument
a variable that responds to the central bank’s tools and indicates the stance of monetary policy
types of policy instruments
reserve aggregates (total reserves, nonborrowed reserves, MB, MB_n) and interest rates (fed funds rate, etc.)
intermediate target
stand between the policy instrument and the goals of monetary policy and are not as directly affected by tools of monetary policy
ex. money aggregates (M1, M2) and interest rates
criteria for choosing the policy instrument
- observability and measurability
- controllability
- predictable effect on goals
Taylor rule
fed funds rate = inflation rate + equilibrium real feds fund rate + 1/2 (inflation rate - inflation target) + 1/2 ((Y_t - Y_pot)/(Y_pot))
Taylor principle
The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate
Phillips curve theory
changes in inflation are influenced by the state of the economy relative to its productive capacity, as well as by other factors
nonaccelerating inflation rate of unemployment (NAIRU)
the rate of unemployment at which there is no tendency for inflation to change
Is the Fed holding the policy rate below r* by to large of a margin?
No, if investors thought low policy rate was unsustainable the expected future interest rates will rise
Why has r* lowered?
- aging demographics, safer assets
- slower rate of technical progress, lower long term growth, weaker investment demand
- global saving glut from emerging markets
Monetary policy tools to prevent deflation
- quantitative easing
- purchase of private sector debt
- forward guidance
- Riase LR inflation target to encourage borrowing and discourage cash hoarding
- reduce interest rate paid on ER
- move from inflation targeting to price level targeting
If UR < NAIRU
GDP growth > potential GDP
- inflation rises
If UR > NARIU
GDP growth < potential GDP
- inflation falls
if policy rate > r*
then recession
if policy rate < r*
borrowing increases, credit increases, money increases, inflation increases, and policy rate increases
Why is it bad to have a high inflation target?
- when nominal interest rates = 0, real interest rates will be negative
- when inflation is too high, it’s harder to stabilize
disadvantage of macroprudential polices
subjected to more political pressure than monetary policies
Monetary policy options to prevent deflation and increase expectations
- QE
- buy private sector debt
- Forward guidance
- Raise long run inflation target
- reduce interest rate on reserves
- move from inflation targeting to price level targeting
