Lent - Lecture 4 - Monetary Policy Rules

Question 1

Explain the terms in the Taylor rule: R = r̅ + mπ(π - πt) + mY(Y - Y̅)

Answer 1

• R: real interest rate set by the CB
• r̅: neutral real interest rate, the interest rate during times of no economic shocks
• mπ: policy feedback parameter on inflation
• mY: policy feedback parameter on income

Question 2

What is the value of mY and mπ?

Answer 2

they are greater than 0

Question 3

When R feeds back on Y, what happens to the MP curve?

Answer 3

it becomes upward sloping

Question 4

With the Taylor rule: R = r̅ + mπ(π - πt) + mY(Y - Y̅), what does the slope of the MP equal?

Answer 4

slope= mY

Question 5

What are the two types of policy lags discussed in literature? Briefly describe each one

Answer 5

• inside lag: time from shock hitting economy to change in policy
• outside lag: time from change in policy to being felt

Question 6

What was Friedman’s justification for a passive approach to monetary policy?

Answer 6

If the largest effect from monetary policy is felt 18 months after rates are cut, how can we know the effects will be desirable?

Question 7

Friedman went further than just proposing ‘constant growth in M’. Show that if gY is exogenous, gM can be used to fix the long-run rate of inflation, π*. From this, what was the optimal value of π⃰ according to Friedman, the ‘Friedman rule’

Answer 7

• based on the quantity theory
• MV = PY
• assuming fixed V:
• gM = π* + gY
• if gY exogenous, use gM to fix long-run rate of inflation, π*
• from the Fisher equation in the long run:
• i = r̅ + π*
• choice of π* ⇒ choice of i
• ‘i is a tax on choice to hold cash → efficient to have i = 0’
• ‘Grow M so that π* = -r̅’ ,→ the ‘Friedman rule’

Question 8

Give 2 arguments against Friedman’s view that monetary policy should take a passive approach

Answer 8

• disputes about policy lags: very hard to estimate cleanly
• successes of policy activism - especially ‘Great Moderation’

Question 9

The Friedman rule seems counter-intuitive because it suggests CBs should actively try to hit the ZLB. Why did Friedman think they should do this, when the ZLB makes monetary policy impotent?

Answer 9

For Friedman active policy was counter-productive anyway

Question 10

What is the current consensus among macroeconomists regarding policy activism?

Answer 10

Large consensus among macroeconomists today in favour of monetary policy activism – especially post-crisis