Final: Monetary Policy and Rules

Question 1

Why Deviation(s) in Real Income are Bad

Answer 1

Deviations of real output from it’s natural rate are wasteful and based on misinformation
-Real output below natural rate= recession, loss of output/employment
-Real output above natural rate = loss of leisure, economy running hot

Risk averse people prefer to live in a less variable economy

Question 2

Real output below natural rate=

Answer 2

recession, loss of output/employment

Question 3

Real output above natural rate=

Answer 3

loss of leisure, economy running

Question 4

Hierarchical Mandates

Answer 4

Price level stability first, other goals follow only if they conform to the first.

Question 5

Dual Mandates

Answer 5

Price stability + another goal of equal importance
Like boosting or stabilizing output/ employment

However, sometimes these goals conflict

At a minimum, they allow for more discretion and push away from rules.

Question 6

Instrumental Independence

Answer 6

A central bank is given a task or goal to pursue but is allowed to achieve that goal in whatever manner it sees fit.
That is, the central bank can use any monetary policy tool, or combination of tools to achieve it.

Seems to be intuitively a good thing
I.e. Central banks should know better which levers to pull to achieve a given policy outcome, in comparison to politicians.

Question 7

Goal Independence

Answer 7

The central bank is free to choose what monetary policy goals it pursues
Activist or stabilization policy
Rule-based monetary policy
Choice of rule and implementation

Question 8

Benefits of Goal Independence

Answer 8

Political economy

A central bank with goal independence is ostensibly immune to pressure from the government or treasury
Without goal independence, this pressure often results (especially in developing countries) in the central bank being forced to directly finance government deficits
Inflationary finance
Currency, debt, and banking crises

Being immune to political pressures has benefits

Some may also view it as undesirable for non-economists (politicians) having the power to determine the goals of monetary policy

Question 9

Costs of Goal Independence

Answer 9

Political economy
Lack of political accountability
A central bank with goal independence is a technocratic institution
It runs afoul of basic democratic notions regarding citizens in a representative democracy being able to directly/indirectly choose government policy.

Public choice considerations
Central banks hire loads of economists. If constrained to the enforcement/implementation of a simple monetary policy rule, the payroll could be decimated.
The fact that inflation generates seigniorage presents an eternal conflict of interest
And the Fed doesn’t send 100% of seigniorage revenue back to the treasury
Fedwatching industry

Time Inconsistency

Question 10

Monetarist objections to Discretionary Policy

Answer 10

Central bank policy moves are too often ill‑timed or ill-measured due to “long and variable lags“ from ΔM to Δ other variables
activist policy in practice pushes y farther away from y_n rather than closer
Periods of slow gM are periods of slow gY, so policy isn’t offsetting M^d shocks

Question 11

Monetary Policy in a Wicksellian Framework

Answer 11

Monetary policy disturbs the interest rate, and therefore the intertemporal allocation of goods.

Causing business cycle risk
And also permanent losses from bad investment (assuming MP raised the interest rate)
Wicksell’s “natural” rate
If FFR<R, expansion
IF FFR>R, contractions

Question 12

Monetary Policy and Austrian Theory of the Business Cycle

Answer 12

Central bank lowers interest rates through monetary expansion

Bad (mal)investments are made at these artificially low interest rates

Once the true scarcity of current loanable funds becomes apparent, the interest rate creeps up, and many marginal projects undertaken at artificially low interest rates go under.

This causes a recession/depression and the unemployment of capital/labor

Question 13

Friedman k% rule

Answer 13

Make some measure of the money stock grow at a constant rate (k%) per year.
k is constant and does not vary
Which monetary aggregate? The one with the most stable velocity, so that nominal income MV is relatively stable.
Historically this is M2

Question 14

k% rule: controlling M growth

Answer 14

Tighten the Fed’s control over the monetary base (H) by
Eliminating gold redemption of the dollar
Nixon did this
Closing the discount window (no loans to banks)

Reduce variability in the money multiplier (M/H) by:
100% reserve requirements on all bank-issued components of the target M.
I.e. If M1, 100% reserves for deposits
Or, make reserve ratios uniform across all of M2 and fix the ratios permanently.
Pay competitive interest on reserve deposits with the Fed to reduce the interest-sensitivity of reserve demand.

Question 15

Issues with k% rule

Answer 15

Velocity turned out not to be stable.

Real income differential

Question 17

Friedman: Freexe the monetary bade

Answer 17

Variant of the k% rule
Freeze the monetary base (H)
k=0

Friedman grew fond of public choice considerations, and opted for a rule that reduces the chance that obstinate bankers could thwart it.
CB bureaucracy could be sent home

Commercial banks would be allowed to issue currency
Free banking

Would allow for a mild price deflation
If gy outruns gV (since gM=0, gP= 0) due to innovations in the payments system.
Depends on M1 creation (banks, regulations thereof, etc.)

Question 18

Mcallum’s Rule

Answer 18

Nominal income (NGDP) targeting
Money growth rule with feedback
Better than a stable price level gP=0 rule.
The goal of the central bank is to maintain nominal income gY equal to the long-run moving average of real output (gy), plus the desired inflation rate gP*
gP* can be set to zero.

Question 19

Benefits of Mcallum’s Rule

Answer 19

Allows permanent changes in P from changes in productivity