Transcript Slide 1

CHAPTER 25
CHAPTER25
Monetary Policy: A
Summing Up
Prepared by:
Fernando Quijano and Yvonn Quijano
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Chapter 25: Monetary Policy: A Summing Up
25-1
The Optimal Inflation Rate
Table 25-1
Inflation Rates in the OECD, 1981-2000
OECD average*
Number of countries with
inflation below 5%**
1981
1985
1990
10.5%
6.6%
6.2%
10
15
2
1995
2003
5.2%
21
2.0%
27
* Average of GDP deflator inflation rates, using GDPs at PPP prices as weights.
**Out of 30 countries.
Inflation has steadily gone down in rich countries
since the early 1980s.
The attempt to reduce it even further depends on
the costs and benefits of inflation.
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Monetary Policy: What You Have Learned
and Where
A quick review of Chapters 4 through 24 and an overview of the
information presented in Chapter 25
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Chapter 25: Monetary Policy: A Summing Up
The Costs of Inflation
We’ve seen how very high inflation can disrupt
economic activity. The debate in OECD countries
today, however, centers on the advantages of,
say, 0% versus 4% inflation a year. Within that
range, economist identify four main costs of
inflation: (1) shoe-leather costs, (2) tax
distortions, (3) money illusion, and (4) inflation
variability.
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Chapter 25: Monetary Policy: A Summing Up
Shoe-Leather Costs
Shoe-leather costs are the costs of
making more trips to the bank in the
presence of inflation. They reflect an
increase in the opportunity cost of holding
money.
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Chapter 25: Monetary Policy: A Summing Up
Tax Distortions
Tax distortions occur when tax rates do not
increase automatically with inflation, a concept
known as bracket creep. Income for purposes of
taxation includes nominal interest payments, not
real interest payments.
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Chapter 25: Monetary Policy: A Summing Up
Money Illusion
Money illusion is the cost of inflation
associated with the notion that people
make systematic mistakes in assessing
nominal versus real changes, leading
people to make incorrect decisions.
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Chapter 25: Monetary Policy: A Summing Up
Inflation Variability
Inflation variability means that financial
assets such as bonds, which promise
fixed nominal payments in the future,
become riskier.
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Money Illusion
After conducting a survey, it’s suggested that money illusion is
very prevalent and that people have a hard time adjusting for
inflation.
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Chapter 25: Monetary Policy: A Summing Up
The Benefits of Inflation
Inflation is actually not all bad. One can identify
three benefits of inflation: (1) seignorage, (2) the
option of negative real interest rates for
macroeconomic policy, and (3) the use of the
interaction between money illusion and inflation
in facilitating real wage adjustments.
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Chapter 25: Monetary Policy: A Summing Up
Seignorage
Seignorage, or the revenues from money
creation, allow the government to borrow less
from the public, or to lower taxes.
An economy with a higher average inflation rate
has more scope to use monetary policy to fight a
recession.
The presence of inflation allows for downward
real-wage adjustments more easily than when
there is no inflation.
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Chapter 25: Monetary Policy: A Summing Up
The Option of Negative
Real Interest Rates
In short, an economy with a higher average
inflation rate has more scope to use monetary
policy to fight a recession. An economy with a
low average inflation rate may find itself unable
to use monetary policy to return output to a
natural level of output.
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Chapter 25: Monetary Policy: A Summing Up
Money Illusion Revisited
Paradoxically, the presence of money illusion
provides at least one argument for having a
positive inflation rate. The presence of inflation
allows for downward real-wage adjustments
more easily than when there is no inflation.
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Chapter 25: Monetary Policy: A Summing Up
The Optimal Inflation Rate:
The Current Debate
Those who aim for small but positive inflation
argue that some of the costs of positive inflation
can be avoided, and the benefits are worth
keeping.
Those who aim for zero inflation argue that this
amounts to price stability, which simplifies
decisions and eliminates money illusion.
Today, most central banks appear to be aiming
for a low but positive inflation, between 2 and
3%.
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Chapter 25: Monetary Policy: A Summing Up
25-2
The Design of
Monetary Policy
Most central banks have adopted an inflation rate
target rather than a nominal money growth rate
target. And, they think about short-run monetary
policy in terms of movements in the nominal
interest rate rather than in terms of movements in
the rate of nominal money growth.
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Chapter 25: Monetary Policy: A Summing Up
Money Growth Targets and
Target Ranges
Until the 1990s, monetary policy, in the US and
other OECD countries, was typically conducted
as follows:
 The central bank chose a target rate for
nominal money growth corresponding to the
inflation rate it wanted to achieve in the
medium run.
 In the short run, the central bank allowed for
deviations of nominal money growth from the
target.
 To communicate to the public both what it
wanted to achieve in the medium run and
what it intended to do in the short run, the
central bank announced a range for the rate
of nominal money growth.
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Chapter 25: Monetary Policy: A Summing Up
Money Growth and Inflation Revisited
Figure 25 - 1
M1 Growth and
Inflation: 10-year
averages, 1970-2003
There is no tight relation
between M1 growth and
inflation, not even in the
medium run.
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Chapter 25: Monetary Policy: A Summing Up
Money Growth and Inflation Revisited
The relation between M1 growth and inflation is
not tighter because of shifts in the demand for
money.
When people reduce their bank account
balances and move to money market funds,
there is a negative shift in the demand for money.
Frequent and large shifts in money demand
created serious problems for central banks.
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Chapter 25: Monetary Policy: A Summing Up
Inflation Targeting
In many countries, central banks have defined as
their primary goal the achievement of a low
inflation rate, both in the short run and in the
medium run. This is known as inflation
targeting.
 Trying to achieve a given inflation target in the
medium run would seem a clear improvement
over trying to achieve a nominal money
growth target.
 Trying to achieve a given inflation target in the
short run would appear to be much more
controversial.
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Chapter 25: Monetary Policy: A Summing Up
The Unsuccessful Search for the
Right Monetary Aggregate
Measures that include not only money but other
liquid assets are called monetary aggregates,
under the name of M2, M3, and so on.
In the United States, M2 is also called broad
money.
The central bank could choose M2 growth as
target, however the relation between M2 growth
and inflation is not very tight either, and the
central bank does not control M2. Many financial
assets are very liquid, which makes them
attractive as substitutes for money. However,
these assets are not included in M1.
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Chapter 25: Monetary Policy: A Summing Up
The Unsuccessful Search for the
Right Monetary Aggregate
Figure 1
M2 Growth and
Inflation: 10-year
averages, 1970-2003
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Chapter 25: Monetary Policy: A Summing Up
Inflation Targeting
The result that we have just derived – that
inflation targeting eliminates deviations of output
from its natural level – is too strong, however, for
two reasons:
 The central bank cannot always achieve the
rate of inflation it wants in the short run.
 Like all other macroeconomic relations, the
Phillips curve relation does not hold exactly.
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Chapter 25: Monetary Policy: A Summing Up
Interest Rate Rules
According to the Taylor rule, since it is the
interest rate that directly affects spending, the
central bank should choose an interest rate
rather than a rate of nominal money growth.
it  i *  a( t   *) b(ut  un )
Taylor’s rule provides a way of thinking about
monetary policy: once the central bank has
chosen a target rate of inflation, it should try to
achieve it by adjusting the nominal interest rate.
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Chapter 25: Monetary Policy: A Summing Up
Interest Rate Rules
it  i *  a( t   e )  b(ut  un )
 If  t   *, and ut  un , then the central bank
should set it equal to its target value, i*.
 If inflation is higher than the target ( t   *) , the
central bank should increase the nominal
interest rate it above i*.
 If unemployment is higher than the natural rate
of unemployment (u>un), the central bank
should decrease the nominal interest rate.
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Chapter 25: Monetary Policy: A Summing Up
Interest Rate Rules
Since it was first introduced, the Taylor rule has
generated a lot of interest, both from researchers
and from central banks:
 Researchers looking at the behavior of both
the Fed in the US and the Bundesbank in
Germany have found the rule describes their
behavior over the last 15-20 years.
 Other researchers have explored whether it is
possible to improve on this simple rule.
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Chapter 25: Monetary Policy: A Summing Up
Interest Rate Rules
Since it was first introduced, the Taylor rule has
generated a lot of interest, both from researchers
and from central banks:
 Yet other researchers have discussed whether
central banks should adopt an explicit interest
rate rule and follow it closely.
 In general, most central banks have now
shifted to thinking in terms of an interest rate
rule.
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Chapter 25: Monetary Policy: A Summing Up
25-3
The Fed in Action
The mandate of the Federal Reserve System
was most recently defined in the HumphreyHawkins Act, passed by Congress in 1978.
For more information on how the Fed is
organized, go to the Fed’s Web site:
www.federalreserve.gov/
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Chapter 25: Monetary Policy: A Summing Up
The Organization of the Fed
The Federal Reserve System is composed of
three parts:
 A set of 12 Federal Reserve Districts
 The Board of Governors
 The Federal Open Market Committee
(FOMC) and the Open Market Desk.
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Chapter 25: Monetary Policy: A Summing Up
The Instruments of Monetary Policy
H  [c   (1  c)]$YL(i )
The equilibrium interest rate is the interest rate at
which the supply (left side) and the demand (right
side) for central bank money are equal.
The money supply, H, refers to the monetary
base. The demand for money is the sum of the
demand for currency and the demand for
reserves by banks (refer to chapter 4 for more
detail).
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Chapter 25: Monetary Policy: A Summing Up
Reserve Requirements
Reserve requirements are the minimum amount
of reserves that banks must hold in proportion to
checkable deposits.
By changing reserve requirements, the Fed
effectively changes the demand for central bank
money.
This instrument of monetary policy is not widely
used because banks may take drastic actions to
increase their reserves, such as recalling some
of the loans.
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Chapter 25: Monetary Policy: A Summing Up
Lending to Banks
The Fed can also lend to banks, thereby affecting
the supply of central bank money.
The set of conditions under which the Fed lends
to banks is called discount policy. The Fed
lends at a rate called the discount rate, through
the discount window.
Today, changes in the discount rate are used
mostly as a signal to financial markets.
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Chapter 25: Monetary Policy: A Summing Up
Open-Market Operations
Open-market operations, the purchase and sale
of government bonds in the open market, is the
main instrument of U.S. monetary policy. It is
convenient and flexible.
When the Fed buys bonds, it pays for them by
creating money, thereby increasing the money
supply, H. When it sells bonds, it decreases H.
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Chapter 25: Monetary Policy: A Summing Up
The Implementation of Policy
The most important monetary policy decisions
are made at meetings of the FOMC.
Fed staff prepares forecasts and simulations of
the effects of different monetary policies on the
economy, and identifies the major sources of
uncertainty.
The conduct of open-market operations between
FOMC meetings is left to the Open Market Desk.
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Chapter 25: Monetary Policy: A Summing Up
The Implementation of Policy
Does the Fed have an inflation target, or follow
an interest rate rule?
 The answer is: we don’t know. The Fed
chairman, Alan Greenspan, is renowned for
his lack of transparency.
 The evidence strongly shows that the Fed
has in fact an implicit inflation target of about
2-3%. It is also clear that the Fed adjusts the
federal funds rate in response both to the
inflation rate and to deviations of
unemployment from the natural rate.
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Chapter 25: Monetary Policy: A Summing Up
The Implementation of Policy
Does the Fed have an inflation target, or follow
an interest rate rule?
 Many economists say: Do not argue with
success. So far, the record of monetary
policy under Greenspan has been
outstanding.
 Other economists are more skeptical. They
argue that it is unwise to have monetary
policy depend so much on one individual,
that the next Chairman of the Fed may not be
able to achieve the same mix of credibility
and flexibility.
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Chapter 25: Monetary Policy: A Summing Up
The Implementation of Policy
Figure 25 - 2
The Federal Funds Rate,
1987-2004
In 1990-1992, and again in
2001, the Fed dramatically
decreased the federal
funds rate to try to avoid a
recession.
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Chapter 25: Monetary Policy: A Summing Up
Key Terms








shoe-leather costs
money illusion
liquid asset
monetary aggregates,
broad money (M2)
inflation targeting
Taylor’s rule
Humphrey-Hawkins Act
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 Federal Reserve Districts
 Board of Governors
 Federal Open Market Committee
(FOMC)
 Open Market Desk,
 reserve requirements
 discount policy
 discount rate
 discount window
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