What Should Central Banks Do?

1. What Should Central Banks Do? Chapter 16

2. Price Stability Goal • Price stability = low and stable inflation • Price stability is desirable because: • Inflation hampers economic growth – makes decisionmaking very difficult for consumers, businesses, and gov’t • Inflation makes it difficult to plan for the future • Inflation can cause social conflict • Arbitrary redistribution of wealth • People competing with each other to ensure that their incomes keep up with inflation

3. The Role of a Nominal Anchor • Nominal anchor = a nominal variable such as the inflation rate or the money supply which ties down the price level to achieve price stability • Nominal anchors • Promote price stability directly by promoting low and stable inflation expectations • Limit the time-inconsistency problem

4. Time-inconsistency Problem • Time inconsistency problem = a situation in which someone has incentives to make a promise but later renege on it; because of these incentives, others don’t believe the promise

5. Monetary Policy and Time-inconsistency • Monetary policymakers are always tempted to pursue a discretionary monetary policy that is more expansionary than firms or people would expect • The best policy is NOT to pursue expansionary policy – the alternative is that people come to expect periodic expansions, which raise prices but leave output and employment unchanged. • Even if central bank realizes this, they still are likely to engage in expansionary policy due to political pressures.

6. Solving the Time-inconsistency Problem • Conservative policymakers – central bank official who believe it is more important to keep inflation low than to stimulate output • Reputation – if policymakers care about their reputations then the time-inconsistency problem can be mitigated; this happens when policymakers have long time horizons – if they place a large weight on how their actions today affect the future. Then the costs of raising expected inflation are a strong deterrent to inflation. • A policy rule – the government imposes a rule requiring the central bank to produce low inflation

7. Other Goals of Monetary Policy • High employment • Economic growth • Stability of financial markets • Interest-rate stability • Stability in foreign exchange markets

8. High Employment • High employment (low unemployment) is a worthy goal for two reasons • High unemployment sucks • Loss of output (i.e., low GDP) • The goal for high employment is the natural rate of unemployment

9. Economic Growth • Closely related to high-employment, because businesses won’t invest in capital when unemployment is high • There is active debate about the role monetary policy plays in promoting economic growth

10. Stability of Financial Markets • Financial crises should be avoided • Avoid financial uncertainty which can reduce output • In a crisis, financial markets are hindered in channeling funds to those with productive investment opportunities, leading to a sharp contraction in economic activity.

11. Interest-rate Stability • Fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future • The stability of financial markets is also fostered by interest-rate stability.

12. Stability in Foreign Exchange Markets • A rise in the dollar makes American industries less competitive with those abroad, while a decline in the dollar stimulates inflation in the U.S. • Preventing large changes in the value of the dollar it makes planning for international commerce/investment easier.

13. Price Stability as the Primary Goal? • In the long run there is no inconsistency between the price stability goal and the other goals. • The natural rate of unemployment is not lowered by high inflation, so higher inflation cannot produce more employment/output in the long run. • In the long run, price stability promotes economic growth as well as financial and interest-rate stability. • There IS a short-run trade-off with the goals of high employment and interest-rate stability

14. Hierarchical mandate • The Maastricht Treaty, which created the ECB, states “The primary objective of the European System of Central Banks [ESCB] shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community.”

15. Dual Mandate • “The Board of Governors of the Federal Reserve System and the FOMC shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

16. Monetary Targeting • Advantages • Almost immediate signals help fix inflation expectations and produce less inflation. • Almost immediate accountability for monetary policy to keep inflation low – helps constrain policymaker from falling into time-inconsistency trap. • Disadvantage • There must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate.

17. Inflation Targeting • Inflation targeting involves several elements • Stated numerical target for inflation • Commitment to price stability as the primary long-run goal • Use a great deal of information to decide on policy • Transparency via communication with the public • Accountability for meeting the target

18. Inflation Targeting • Advantages • Does not rely on just one variable to achieve the target. • Readily understood by the public and is thus highly transparent. • Reduced time-inconsistency trap due to increased accountability • Stresses transparency, and thereby improves private sector planning by reducing uncertainty about monetary policy, interest rates, and inflation

19. Inflation Targeting • Disadvantages • Delayed signaling • Too much rigidity • Potential for increased output fluctuations • Low economic growth during disinflation

20. Implicit Nominal Anchor • Fed under Greenspan pursued a strategy involving an implicit but not an explicit nominal anchor in the form of an overriding concern by the Fed to control inflation in the long run. • Involves forward-looking behavior in which there is careful monitoring for signs of future inflation.

21. Implicit Nominal Anchor • Advantages • Uses many sources of information • Avoids the time-inconsistency problem • Demonstrated success • Disadvantages • Lack of transparency and accountability • Strong dependence on the preference, skills, and trustworthiness of individuals in charge • Inconsistent with democratic principles

22. Fed Under Bernanke • Fed under Bernanke has been moving toward inflation targeting • Recent steps by the Fed to increase transparency • FOMC members create long-run forecasts for, among other things, the inflation rates, and these forecasts are reported to the public • Shortened the time before FOMC minutes released • Immediately following FOMC meeting they immediately announce changes to Fed Funds target rate • Announced a “balance of risks” toward either high inflation or toward a weaker economy

23. Policy Instruments • Central banks have three tools – reserve requirements, discount operations, and open market operations • The policy (or operating) instrument = a variable that responds to the central bank’s tools and indicates the stance (easy or tight) of monetary policy. • There are two basic policy instruments • Reserve aggregates: total reserves, nonborrowed reserves, the monetary base, and the nonborrowed base • Interest rates: federal funds rate and other short-term interest rates • Focus on intermediate target – variable not as directly affected by monetary policy tools, but linked to policy goals

24. Criteria for Choosing the Policy Instrument • The instrument must be observable and accurately measurable • Reserve aggregates easy to measure, but only released every two weeks • Interest rates instantaneously observable, but you’re observing nominal (as opposed to real) rates • Must be controllable by the central bank • Reserves not perfectly controlled because of currency drains • Can control short-term nominal rates, but not real rates (since you can’t affect inflation expectations) • Must have a predictable effect on the goals

25. The Taylor Rule • Taylor Rule: Fed Funds Rate Target = inflation rate + equilibrium real fed funds rate + ½(inflation gap) + ½(output gap) • Assumed target inflation is 2%, eqbm fed funds rate of 2% • Output gap is how far above or below you are from full employment output • Full employment output = output when unemployment rate equals the natural rate of unemployment • NAIRU = non-accelerating inflation rate of unemployment – the unemployment rate at which inflation has no tendency to change