Conduct of Monetary Policy: strategy and tactics

Question 1

The Price Stability Goal

Answer 1

Maintaining a stable price level is seen as a goal of economic policy.
- Rising price levels cause uncertainty in an economy

Price stability is defined as low and stable inflation.

Highlights the importance of a nominal anchor.
» a nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability.

Adherence to a nominal anchor (could be adherence to a target inflation rate) that keeps the nominal variable within a narrow range promotes price stability by directly promoting low and stable inflation expectations
.
» Nominal anchor can also limit the time-inconsistency problem

Question 2

Time inconsistency problem

Answer 2

Policy makers attempt to pursue monetary policy that is more expansionary than expected.

Why?
This policy would boost economic output (and lower unemployment) in the short run.

Best policy, however, do not pursue expansionary policy, as this can affect workers’ and firms’ expectations about inflation.

Question 3

Inflation through expectations

Answer 3

Inflation can be determined by either rational expectations (strong assumption) or adaptive expectations

Question 4

Nominal anchor as a behavioural rule

Answer 4

Set the rule and then stick to it so that:

π=πe =πT where πT denotes inflation target

• Volatile inflation distorts resource allocation with changes in relative price changes
• Menu costs
• Decreased value of savings

Deflation causes deflationary trap: the nominal interest rate hits the ZLB
- Weak demand pushes inflation down – causes real interest rate up and suppresses demand
- Increased real value of debt

Question 5

Other goals of monetary policy

Answer 5

• High employment and output stability
• Economic growth.
• Stability of financial markets
• Stability in foreign exchange markets.
• Interest rate stability

Question 6

High employment and output stability

Answer 6

(1) the alternative situation—high unemployment—causes much human misery; and (2) when unemployment is high, the economy has both idle workers and idle resources (closed factories and unused equipment), resulting in a loss of output (lower GDP).

Frictional unemployment is when workers are out of the work force to start a family etc or may take time finding the job they want. Structural unemployment is when there’s a mismatch between a firm and a worker’s skillset

• Natural rate of unemployment. the point at which the demand for labour equals the supply of labour.

The high employment goal can be thought of in another way. Because the level of unemployment is tied to the level of economic activity in the economy, a particular level of output is produced at the natural rate of unemployment, which naturally enough is referred to as the natural rate of output but is more often referred to as potential output.

Question 7

Economic growth.

Answer 7

promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. In fact, this approach is the stated purpose of supply-side economics policies, which are intended to spur economic growth by providing tax incentives for businesses to invest in facilities and equipment and for taxpayers to save more.

Question 8

Stability of financial markets

Answer 8

• Instability in financial markets hinders transfers of funds between savers and borrowers

Question 9

Stability in foreign exchange markets.

Answer 9

A rise in the value of the dollar makes American industries less competitive with those abroad, and a drop in the value of the dollar stimulates inflation in the United States. In addition, preventing large changes in the value of the dollar makes it easier for firms and individuals purchasing or selling goods abroad to plan.
PBOC has its main mandate as stability in the foreign exchange market

Question 10

Interest rate stability

Answer 10

fluctuations in interest rates can cause uncertainty in an economy

Question 11

Should price stability be the main goal of MP

Answer 11

Hierarchical mandates put the goal of price stability first, then others can follow. – ECB, BoE, Bank of New Zealand all have this

» Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability).
– The FED has this

Because low and stable inflation rates promote economic growth, central bankers have come to realize that price stability should be the primary, long-run goal of monetary policy.

Nevertheless, because output fluctuations should also be a concern of monetary policy, the goal of price stability should be seen as primary only in the long run. Attempts to keep inflation at the same level in the short run, no matter what else is happening in the economy, are likely to lead to excessive output fluctuations.

Question 12

Inflation targeting as an MP strategy

Answer 12

Inflation targeting involves several essential elements:
* » Public announcement of medium-term numerical target for inflation.
* » Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal.
* » Information-inclusive approach in which many variables are used in making decisions.
* » Increased transparency of the strategy.
* Communication to the public and financial markets: media, minutes, reports etc.
* » Increased accountability of the central bank.

Question 13

Advantages of inflation targeting

Answer 13

» Does not rely on one variable to achieve target.
» Easily understood.
» Reduces potential of falling in time-inconsistency trap – numerical target increases accountability of CB

• Improved performance

» Stresses transparency and accountability.

The inflation-targeting framework promotes the accountability of the central bank to elected officials, who are given some responsibility for setting the goals of monetary policy and then monitoring the economic outcomes. However, under inflation targeting as it generally has been practiced, the central bank has complete control over operational decisions and so can be held accountable for achieving its assigned objectives.

Question 14

Disadvantages of inflation targeting

Answer 14

» Delayed signalling.

» Too much rigidity – reduced capacity to respond to unforeseen circumstances

» Potential for increased output fluctuations.

a sole focus on inflation may lead to monetary policy that is too tight when inflation is above target and thus may result in larger output fluctuations. Inflation targeting does not, however, require a sole focus on inflation—in fact, experience has shown that inflation targeters display substantial concern about output fluctuations.

» Low economic growth during disinflation.

Question 15

Monitoring inflation expectations

Answer 15

Every central bank devotes considerable amount of resources to monitor inflation expectations.
* » For example, BoE has a quarterly survey.
* » Respondents expected prices to rise over the coming year by 3.2% (households) in August 2022 and 7.6% (companies) in October 2022. This is not the same as forecasting inflation:
* » Forecasting is about what will (most likely) happen.
* » Expectations are about what firms and households think will happen.
They can be wrong.
* » Expectations, however, can be self-fulfilling.

If every firm expects 7.6% inflation and raise prices accordingly, then inflation is going to be 7.6%.

Question 16

Can a CB be wrong when it forecasts its inflation?

Answer 16

Point estimates are typically wrong.
Implies the CB cannot stabilise the economy perfectly.
» The fan chart depicts the probability of various outcomes for CPI inflation in the future.
» Shows outlook of inflation is highly uncertain.
» BoE projects inflation not to return to its target soon.

Question 17

Lessons for MP following the GFC

Answer 17

1. Developments in the financial sector have a far greater impact on economic activity than was earlier realised.
2. The zero-lower bound on interest rates can be a serious problem.
   » Raises questions whether an inflation target of 2% is too low.
3. The cost of cleaning up after a financial crisis is very high.
4. Price and output stability do not ensure financial stability.

» Provide support for perhaps a flexible inflation targeting possibly with higher inflation target.
» Suggest that monetary policy should lean against credit booms but not asset price bubbles.

Question 18

Implications for inflation targeting from these lessons

Answer 18

Two lessons from the crisis—that financial instability can have devastating effects on the economy and that achieving price and output stability does not ensure financial stability

—have led to a recognition that central banks need to pay more attention to financial stability, not only in designing inflation-targeting regimes but also in any monetary policy framework.

Question 19

Asset price bubbles

Answer 19

pronounced increase in asset prices that depart from fundamental values, which eventually burst.

When a credit boom begins, an asset-price bubble may begin to form.

Easier-to-get credit can be used to purchase particular assets and thereby raise their prices

The rise in asset values, in turn, encourages further lending for these assets, either because it increases the value of collateral, making it easier to borrow, or because it raises the value of capital at financial institutions, which gives them more capacity to lend.

The lending for these assets can then further increase demand for them and hence raise their prices even more. This feedback loop—in which a credit boom drives up asset prices, which in turn fuels the credit boom, which drives asset prices even higher, and so on—can generate a bubble in which asset prices rise well above their fundamental values.

Question 20

Other bubbles

Answer 20

• Bubbles that are driven solely by overoptimistic expectations are known as bubbles driven solely be irrational exuberance

Question 21

Value of an asset

Answer 21

The fundamental value of an asset is the present value of the stream of income or services the asset entitles its owner to

Question 22

Argument for not responding to bubbles driven by irrational exuberance

Answer 22

‘Greenspan Doctrine’ reflects five arguments.

• Bubbles nearly impossible to identify.
• Raising interest rates may be ineffective in restraining bubbles.
• Interest rates are a blunt tool.
• Pricking bubbles can have harmful effects on the aggregate economy.
• Better to ease monetary policy aggressively when bubble bursts (supports ‘clean’ argument).
  Monetary policy should not be used to prick bubbles.

Question 23

Argument for responding to bubbles

Answer 23

» The GFC did demonstrate that credit-driven bubble bursts are hard to ‘clean up’.
Important to distinguish between the two bubbles.
* » Instead of ‘leaning’ against potential asset-price bubbles (both types), rather lean against ‘credit booms’.
* » If asset price bubbles are rising while credit is booming, then it is likely that asset prices are deviating from fundamentals - lax credit standards.

Question 24

Effective policies in restraining credit-driven bubbles

Answer 24

Macropudential policy:
» regulatory policy to affect what is happening in credit markets in the aggregate.

Monetary policy:
» Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction.

Question 25

Choosing the policy instrument

Answer 25

• Operating/policy instrument is a variable that responds to the central banks tools and indicates the stance of monetary policy – easy or tight
• Fed has two types: reserve aggregates (total reserves, non-borrowed reserves etc) and interest rates (FFR etc)
• Policy instrument might be linked to an intermediate target such as a monetary aggregate or a long-term interest rate
• Intermediate targets stand between the policy instrument and the goals of monetary policy

Question 26

Can the central bank choose to target both the non-
borrowed reserves and the federal-funds-rate policy instruments at the same time?

Answer 26

the central bank might believe that the best way to achieve its objectives would be to set the federal funds rate
(a policy instrument) at, say, 4%.

The
answer is no. The application of supply and demand analysis to the market for reserves,
developed in Chapter 16, explains why a central bank must choose one or the other.

Central bank might believe that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M2
(an intermediate target), which will in turn be achieved by a growth rate of 3% for
nonborrowed reserves (the policy instrument).

Question 27

Result of targeting on non-borrowed reserves

Answer 27

• supply and demand market for reserves

CB expects demand curve to be at Rd*, but fluctuates between Rd’ and Rd’’ because of unexpected fluctuations in deposits (and hence reserves) and hence changes in desire for banks to hold reserves

If CB has Non-borrowed reserves target of NBR* it will expect federal funds rate to be iff* but this also fluctuates

• therefore, pursuing an aggregate target implies that interest rates will fluctuate

Question 28

Result of targeting on the Federal Funds Rate

Answer 28

diagram shows consequences of interest target set at iff*

as demand curves fluctuate due to unexpected fluctuations of deposits

If demand curve rises to Rd’’ the iff will rise above target and CB will engage in open market purchases of bonds until it raises the supply of NBR to NBR’’, it which point the iff will return to iff*

Iff demand curve falls below Rd’ and the iff drops, CB will keep making open market sales until NBR falls to NBR’’ and iff returns to iff*

Therefore, CB’s adherence to an interest rate target leads to a fluctuating quantity of non-borrowed reserves and the money supply

Question 29

Can you have both interest rate and reserve aggregate targets at the same time?

Answer 29

No, they are incompatible

Can have only one or the other

Question 30

Criteria for choosing the policy instrument

Answer 30

The instrument must be
observable and measurable, it must be controllable by the central bank, and it must
have a predictable effect on the goals.

Question 31

Quick observability and accurate measurement

Answer 31

necessary because such an instrument is useful only if it
signals the policy stance rapidly.

Reserve aggregates like nonborrowed reserves are easily measured, but some lag in the reporting of reserve aggregates (a delay of two weeks)
exists.

Short-term interest rates (like the federal funds rate), by contrast, are not only easy
to measure but also immediately observable. Thus, it seems that interest rates are more
observable and measurable than reserves and are therefore a better policy instrument.

Question 32

effective control

Answer 32

A central bank must be able to exercise effective control over a variable if the variable is to function as a useful policy instrument. If the central bank cannot control the policy instrument, knowing that it is off track does little good because the central bank has no way of getting it back on track.

Because of shifts into and out of currency, even reserve aggregates, such as non-
borrowed reserves, are not completely controllable.

Conversely, the Fed can control
short-term interest rates, such as the federal funds rate, very tightly. It might appear,
therefore, that short-term interest rates would dominate reserve aggregates on the
controllability scale.

However, a central bank cannot set short-term real interest rates
because it does not have control over expectations of inflation.

Question 33

predictable effect on a goal

Answer 33

The most important characteristic of a policy instrument is that it must have a predictable effect on a goal such as high employment or price stability.

Question 34

Recent policy instrument choice

Answer 34

In recent years, most central banks have
concluded that the link between interest rates and goals such as stable inflation is stronger
than the link between aggregates and inflation. For this reason, central banks throughout
the world now generally use short-term interest rates as their policy instrument.

Question 35

The Taylor Rule

Answer 35

The Taylor rule indicates that the federal (fed) funds rate should be set equal to
the inflation rate plus an “equilibrium” real fed funds rate (the real fed funds rate that is
consistent with full employment in the long run) plus a weighted average of two gaps:
(1) an inflation gap, current inflation minus a target rate; and (2) an output gap, the
percentage deviation of real GDP from an estimate of its potential (natural rate) level

Question 36

Features of the Taylor rule

Answer 36

An important feature of the Taylor rule is that the coefficient on the inflation gap, ½,
is positive. If the inflation rate rises by 1 percentage point, then the federal funds target
is raised by 1.5 percentage points, and so it is raised by more than a one-to-one ratio. In
other words, a rise in inflation of 1 percentage point leads to an increase in the real federal
funds rate of ½ a percentage point.

Question 37

The Taylor principle

Answer 37

The principle that the monetary authorities should raise
nominal interest rates by more than the increase in the inflation rate has been named the
Taylor principle, and it is critical to the success of monetary policy.

Suppose that the
Taylor principle is not followed and that the rise in nominal rates is less than the rise in
the inflation rate, so that real interest rates fall when inflation rises. Serious instability
then results, because a rise in inflation leads to an effective easing of monetary policy,
which then leads to even higher inflation in the future.

Question 38

The Presence of an output gap in the Taylor rule

Answer 38

Some economists take the view that the presence of an output gap in the Taylor
rule indicates that the Fed should care not only about keeping inflation under control
but also, about minimizing business cycle fluctuations of output around its potential
level.

Caring about both inflation and output fluctuations is consistent with the Fed’s
dual mandate and with many statements by Federal Reserve officials that controlling
inflation and stabilizing real output are important concerns of the Fed.

Question 39

The Phillips curve

Answer 39

An alternative interpretation of the presence of the output gap in the Taylor rule is
that the output gap is an indicator of future inflation, as stipulated in Phillips curve
theory.

Phillips curve theory states that changes in inflation are influenced by the state
of the economy relative to its productive capacity, as well as by other factors. This productive capacity can be measured by potential GDP, which is a function of the natural rate of unemployment, defined as the rate of unemployment consistent with full
employment.

Question 40

Eliminating reserve requirements and the effect on the size of money market market mutual funds

Answer 40

Money Market mutual funds are not subject to reserve requirements and so they avoid the tax effect of reserve requirements and have a cost advantage over banks in acquiring funds.

Eliminating reserve requirements would reduce the cost advantage of money market mutual funds and significantly reduce their size

Question 41

Options available to banks to provide a loan when the bank has no excess reserves

Answer 41

• Go out and borrow from other banks through the money market
• Borrow from corporations
• Or borrow from Central Bank as a last resort to obtain funds to make a loan

Can sell negotiable CDs (certificates of deposit)

Or sell some securities to raise funds

Question 42

Would investors buy stock in a bank that has never had to call in loans, sell securities or borrow as a result of a deposit outflow

Answer 42

No

The fact the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do no earn any interest

This means the banks profits will be low and so stock in the bank is not a good investment