Monetary Policy Revision

Question 1

Explain what a time consistent policy means

Answer 1

When an action planned for time t+i is still optimal to implement at time t+i

Question 2

Explain the components of the Barro-Gordon model. What are the equations?

Answer 2

1. Loss function (min): L=(U-U[])^2 +a(π-π[])^2
2. Phillips Curve (s.t.): U=U^n -b(π-πe)
3. Policy instrument: Government/CB chooses current π
4. Assumed political preferences: U*<Un

Question 3

Explain the constraints with naive population compared to a rational one

Answer 3

Naive: πe = π*
Rational: πe = π

Question 4

How would a CB address the time-inconsistency problem?

Answer 4

1. Reputation: act tougher in early periods
2. Delegation: to people well-known for their aversion towards inflation

Question 5

Explain arguments/limitations to CB independence

Answer 5

Alesina shows that CBs that are independent have lower inflation rates.

However, some consider it undemocratic, it depends on the right central bankers. Selection bias!

Question 6

What is a loss function? What is the intuition? What is the problem CBs face?

Answer 6

Describes a function that needs to be minimised.

The CB will achieve its goal when U = U* and π = π*

The problem is that by changing the inflation rate, they also affect the unemployment rate at a rate which may be different than the effect on the loss function (hence a and b)

Question 7

What is the Phillips Curve? How is unemployment rate derived?

Answer 7

Describes the relationship between the level of unemployment and inflation.

A function of Un and the difference between π and πe

Question 8

What is the Taylor Rule? (and equation)

Answer 8

A rule to which the CB sets its policy instrument as a response to the state of the economy.

i = c + a(π-π[star]) +b(U-U[star])

Question 9

Explain academic examples of monetary policy rules in practice

Taylor

Answer 9

Nechio calculates a Taylor Rule for euro-area. The euro-area aggregate the ECBs interest rate following the rule. The wide gaps in the Taylor rule’s recommendations show that one size cannot fit all when the economic conditions of two regions are so markedly different.

Malmendier estimates a forward-looking Taylor rule that incorporates FOMC members’ experiences of inflation and an interest rate smoothing behaviour. FOMC member average of πe has explanatory power for the federal funds rate over the inflation forecast.

Masciandaro investigates how the presence of women correlates with monetary policy conduct using Taylor rules. CB boards with a higher proportion of women are more responsive to inflation, and have a more conservative approach to monetary policy when inflation is higher.

Question 10

Central banks adjust interest rates more slowly than suggested by optimal Taylor rules. Give 5 reasons for interest rate smoothing

Answer 10

1. Reputation concerns. The bank has to be seen to do what is necessary to keep inflation low
2. Data uncertainty. GDP data comes in with lag
3. Parameter uncertainty, the Taylor rule needs you to estimate the parameters
4. Model uncertainty
5. Financial instability

Question 11

What is the audience of CB communication?

Answer 11

1. Financial market participants
2. Academics
3. Politicians
4. Price setters
5. General public

Question 12

Explain the key principles of CB communication

Answer 12

1. Transparent
2. Should target all audiences
3. Delivered regularly
4. Should not be confusing
5. Equally accessible to all audiences

Question 13

Outline Nakamura’s paper on the information effect

Answer 13

Unexpected changes in interest rates change in the 30 minute window surrounding Fed announcements. Information effects play an important role in the overall causal effect of monetary policy shocks (independent) on output (dependent)

Question 14

Explain CB communication papers

Answer 14

Gurkaynak. Actions do NOT speak louder than words. The statements the fed releases account for 3/4 of movements in Treasury yields. Changes in the fed funds rate target is not enough to account for the movements.

Nakamura. Policy news shock has large and persistent effects on real rates. Small effects on expected inflation. Firms and individuals change expectations based on fed announcements, as does the fed.

Coenen. Communication has increased since the crisis. This lowers market uncertainty, and increases fed credibility. It helps make them transparent.

Cieslak. Policymaker perception of uncertainty creates discrepancies between estimated policy rules and actual decision making. Rising inflation leads to a hawkish stance.

Bliner. Why do they want to communicate? (reasons). If CBs communnicate faster, this leads to a faster adbjustment in demand and therefore inflation. Needs good communication. Three E’s: Explanation, Engagement, Education.

Masciandaro. Evolution of CB communication. Especially via social media. Outlines the increased importance, even for credibility and independence. Before, they would only communicate with financial market participants.

Question 15

Explain the role of Fed information

Answer 15

Should only convey information about its own future policy. However it wants to explain about current and future exogenous shocks

Question 16

Explain findings about policy maker uncertainty

Answer 16

1. Policymaker uncertainty surrounding inflation and the state of the economy means decision making is unpredictable
2. Rising inflation leads to a hawkish stance
3. FOMC reaction reflect the importance of maintaining credibility
4. FOMC shifts between operational modes (economic stability or combating inflation) leads to market surprises

Question 17

Explain how/why the CB attempts to communicate with a broader audience

Answer 17

1. Prominence and visibility of operations
2. Changes in mandates and more complex policy tools require more explanation
3. Some of these changes are controversial which thrusts monetary policy into public debate

Question 18

Explain what the business cycle and output gap means.

Answer 18

The bunching of activity over time. Seen as exogenous shocks to the system

Normative measure to tell us if the economy is performing below its potential. Not always in recession with output gap

Question 19

Explain the assumptions of the RBC model

Answer 19

1. Perfect competition
2. Flexible prices
3. No capital accumulation
4. No fiscal sector
5. Closed economy

Question 20

Explain CCG’s paper on monetary policy rules

Answer 20

From 60s to 80s, the economy experienced high inflation and several recessions.

Estimate a forward-looking monetary policy reaction function before and after Volcker’s appointment as Fed Chairman in 1979.

They find policymakers before did not sufficiently raise Federal Funds in response to expected inflation. As a result, real interest rates decline and fuelled more inflation. Post-Volcker they were more aggression towards expected inflation. The Federal Funds rate was increased enough to ensure real interest rates would rise.

Question 21

Outline the RBC model

Answer 21

Households maximise a utility function, firms maximise profits. There is equilibrium when C = Y. There is no investment, exports, or government. It uses CRA utility.

When we maximise household utility, we get a competitive labour supply schedule, where quantity of labour is a function of wage, given MUc. Consumption is smoothed over time, and consumer less today if interest rate is high.

When we maximise firm profits, we find that output does not depend on prices - business cycles are driven by TECHNOLOGY.

Poor match with empirics!

Question 22

Outline the NK model

Answer 22

Keynes argued there are ineffiencies in the economy that need government intervention.

1. Sticky prices. He introduces “normal” rigidities to make output respond to prices. It assumes there is a reason why prices do not immediately adjust to changes in output - menu/information costs. In practice, prices become less sticky as inflation increases, as you don’t want to get the price wrong!
2. Assumes monopolistic competition (NOT PERFECT), as firms produce slightly different products. Use an adjustment mechanism that assumes there is a fixed probability that a firm adjusts prices. Macro evidence suggests persistent monetary policy effects on real variables. Micro evidence suggests significant price/wage rigitities.
3. Assume competitive labour markets, closed economy, no capital accumulation

Also maximises household utility subject with elasticity of substitution. Assume CRA utility, and log-linearise. Note that the consumption of good j depends on its price and the price level.

Firms face a downward sloping demand curve. The firm produces less and gets a higher price. It has to be taken into account the price declines as more is produced. Assuming Calvo pricing, firms to not reset prices every time period.

The firm maximises its expected future profits. It will choose a price too high to make up for next period. This means too low output, creating a distortion which increases inflation. We have an OUTPUT GAP.

We assume a quadratic loss function. This is minimised wrt nominal interest rate. This yields Ramsey policies.