Expectations and monetary policy

Question 1

What does the Lucas critique imply for the analysis of economic policy?

Answer 1

Empirical associations between variables
- cannot be taken as given/ as constant over time
- depend on expectations and the behavior of decision-makers

Modeling economic decisions is required to capture the dependence of empirical relationships on expectations/decisions

Applications:
- Disappearance of stable, empirical relationships between
inflation and unemployment (Phillips curve) → have to take
changes of expectations into account
- Inflation bias and time inconsistency problem

Question 2

Rules vs discretion

Answer 2

Discretionary decision-making by monetary-policy makers: can imply higher inflation rates, and allows for reacting to unforeseen contingencies

rules provide commitment and anchor expectations (e.g. Taylor rule)

Application: time-inconsistency problem and central bank independence

Question 3

How does time inconsistency of monetary policy decisions affect the inflation rate?

Answer 3

The credibility of the inflation target set by the central bank (no perfect commitment of central bankers to achieve the target)

private households are aware of the lack of commitment (higher expected inflation)

inflation bias if central banks conduct discretionary monetary policy

Mitigation of the bias: monetary-policy rules, reputation building, delegation to an independent decision maker

Question 4

How does the inflation bias occur and how can it be mitigated?

Answer 4

two cases: commitment (expected = real inflation rate) and no commitment (government can reap output gains)

possible mitigation: reputation: central banker with a higher aversion against deviations from the inflation target and central bank independence

Question 5

What is monetarist arithmetic?

Answer 5

Central banks can finance government expenditures by printing money.
Independent central banks have no obligation to do so.

Fiscal dominance of monetary policy: money creation is determined by the budget deficit. Fiscal Rules to limit fiscal dominance.

Seignorage: real revenue of government through money creation. (Dependent on money growth rate and monetary base)

Question 6

What do we mean by unpleasant monetarist arithmetic?

Answer 6

A lower money growth rate may not reduce inflation rate permanently - since no adjustment of fiscal policy (no increase of taxes, no reduction of government expenditures)

Lower revenues from seignorage today require larger revenues from seignorage tomorrow (inflation is postponed)

Question 7

How do hyperinflations happen?

Answer 7

• Government finances are in a precarious situation (more on
  government expenditures and debt in the next sessions)
• Seignorage is an important part of government revenues
• Unexpected inflation reduces the interest payments in real terms for government debt that has been issued previously

Question 8

What are the costs and benefits of inflation?

Answer 8

Optimal inflation 2%

Costs of inflation:
- Shoe-leather costs: higher opportunity costs of holding money due to higher nominal interest rate:
- Tax distortions: Income tax: bracket creep, tax on capital gains: higher tax if the price changes larger
- Money illusion: mistakes in decision making
- Inflation volatility: higher risk

Benefits of inflation:
- Seignorage
- Reductions of real wages, e.g. during a recession, are easier to implement through inflation