Final: Monetary Policy part 2 Flashcards
Suppose money demand increases under nominal interest rate targeting
Excess demand for money at the existing level of nominal income
People try to build up their money balances by saving less
S(LF) curve shifts leftward
In the SR, interest rates increase, even though the underlying real interest rate hasn’t changed.
In the LR the nominal income effect will restore nominal interest rates to the initial position
However, this requires allowing a fall in nominal income and deflation, which may cause a recession
The Taylor Rule
I = gP + 2% + 0.5(lny – lny(n)) + 0.5(gP – gP)
Where:
2% is the assumed real interest rate
y(n) is the assumed natural rate of real output growth
gP is the targeted inflation rate
If inflation (gP) rises by 1%, targeted nominal interest rate (i) increases by 1.5%
Problems with iNterest Rate Targeting
It is possible to target the wrong nominal interest rate given
Changing inflation
And changes in the real interest rate
Friedan’s optimum quantity of money
With positive nominal interest rates, money-holders opt to hold too little money.
More money reduces transaction costs
Given ZLB, 0 is as low as nominal interest rates can go
At zero, this maximizes the benefit to money-holders, as it reduces the opportunity costs of holding money.
Friedman’s OQM: Lower i to 0. Money demand is a function of
Real income
Nominal interest rates (Opp cost.)
MP can’t increase y, but it can lower i.
Friedman’s OQM: Lower i to 0. Why?
Externality argument: Higher money balances are a positive externality
Competitive pricing argument: Central banks should pay a competitive rather monopolistic rate of return on money. Aperfectly competitive fiat money would offer this rate of return
Practically, this means that currency should earn the same rate of return as the shortest duration risk free asset (T-Bills)
This can be achieved by bringing i to zero
Or, if i>0, paying the same return on currency as the shortest duration t-bills
This option was infeasible at the time of Friedman’s writing, and still is unless an interest bearing CBDC/private digital currencies can do this.
Demand Driven Deflation
bad kind
Excess demand for money manifests
Nominal income falls (aggregate demand): Firms contract output, unemploy inputs, Monetarist Business Cycle, It takes time for the economy to adjust back to EQ, in the meantime, recession.
Supply driven deflation
good kind
Positive supply shocks: Productivity increases, Selgin’s Productivity Norm
Under deflation and inflation who gets defrauded?
Inflation defrauds lenders, enriches borrowers
Deflation defrauds borrowers , enriches lenders
Inflation Targeting
1) Public announcement of medium-term numerical objectives (targets) for inflation
2) Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieving the goal
3) An information-inclusive approach where many variables are monitored (Not just monetary aggregates)
4) High transparency with the public
Expectations
5) Accountability for the CB
Inflation Targeting Benefits
1) Reduction of time inconsistency (Transparency)
2) Increased transparency
3)Increased accountability
(Easily measured success
Like other rules, consistent with democratic principles)
Inflation Targeting Costs
1) Loss of Discretion
2) Output swings
Tight MP when inflation is high and vice versa, may induce “mini recessions”
3) Delayed signals
Long and variable lags
4) No benign price level changes
Price changes due to real changes in output (negative shocks, increases in productivity) are “papered over” reduces the functionality of prices to propagate the market mechanism.
Key benefit of nominal income targeting
Hayek’s Stable MV Norm. For a given M, if V increases or decreases…
For a given M, if V increases (fluidity decreases), excess supply of money, inflation
For a given M, if V decreases (fluidity increases), excess demand for money, deflation
Dangers of monetary disequilibrium. Costs of Inflation (short-term non-neutrality of M on y,r)
Price system noise, shoe-leather costs, complicates financial planning, etc.
For Austrians, boom leads to bust, via liquidity effects of increased M on the real interest rate
Dangers of monetary disequilibrium. Costs of deflation (short-term non-neutrality of M on y,r)
Business cycles and production incentives
Debt-deflation
Recall, deflation enriches creditors at the expense of debtors (i.e. increases the real value of debt)
What happens to the banking system if loans are defaulted upon on mass?
Hayek’s stable MV norm solution for changes in V
If V increases (fluidity decreases), use monetary policy to decrease M.
If V decreases (fluidity increases), use monetary policy to increase M.
In other words, keep MV constant.
What is the why behind the solutions for changing V under Hayek’s stable MV norm?
If MV is constant, changes in P only result from changes in y, or as a result of supply shocks/changes
Hayek viewed this as useful, as it conveyed information crucial to the operation of the market process
Concept of benign deflation
Nominal Income Targeting targets what?
Shares the inclusion of the price level with the inflation target
Allows to fluctuations in real GDP
NGPDLT is Rule-Based MP that mitigates what
Mitigates the time inconsistency problem
Mitigates public choice issues surrounding discretion
NGPDLT is easier to implement than what and why?
Easier to implement than an inflation target
NGDPLT doesn’t have to worry about correcting for supply shocks
Less cases in which money growth is used to stabilize nominal income, income comparison to inflation targeting
Lower menu costs
Costs of NGDP targeting
Accurate estimates of GDP growth
Less transparent/more complicated
Harder to be monitored by the public
Explain Nominal Income Targeting Adjusts for Velocity
Changes in the demand for money are automatically offset by changes in the supply under NGPDLT
Looser money when people are inclined to hold more money
V decreases
Tighter money when spending is rapid
V increases
NGDPLT and supply shocks
When price level changes reflect underlying changing in the productive capacity of an economy, it is good to let them persist.
Supply shocks
What type of shocks should NGDPLT manage?
Demand shocks.
Demand shocks push economic activity and the price level in the same direction
Too much spending = inflation and vice versa. MP corrects both at once.
Growth path vs growth rate targeting
NGDP level targets make up for past misses
Growth path anchors expectations
Public expects CB to restore the nominal income to its long-run path if there is a deviation
This stabilizes the path in its own right
Alternative?
The CB can implement a growth rate target which doesn’t make up for past misses.
Requires less drastic swings in MP, and therefore inflation/deflation
Advantages of Selgin’s Productivity Norm
Lower costs of price adjustment
“Less likely to invite monetary misperception effects”
Less disturbing to fixed nominal contracts
“generally keeps the money stock closer to its “optimum” level”. `Reduces money disequilibrium.
Menu Costs
Menu costs are the costs of nominal price adjustment
The more prices that need to be changed, the higher the costs.
What happening for increases and decreases in V and y under zero inflation (Stable P) and productivity (stable py)
V increases -> zero inflation (M decreases) - > productivity (M decreases)
V decreases -> zero inflation (M increases) - > productivity (M increases)
y increases -> zero inflation (M increases) - > productivity (no change. let P fall)
y increases -> zero inflation (M decreases) - > productivity (no change. let P rise)
The Taylor rule is an example of
inflation rate targeting
