Chapter 21:Learning Objectives

What is Monetarism? The Central Role of Expectations:

Adaptive vs. Rational Rules vs. Discretion: Time Inconsistency

in Policy The Quantity Theory vs. “Real Bills” The Causal Role of Money

Monetarism

In the long-run, money is neutral so it has no real economic effects

Inflation is a purely monetary phenomenon Business cycles are explained by active

monetary policy Money causes inflation and economic activity

(in the short-run) not the other way around

The Role of Expectations

Adaptive Expectations involve forecasting inflation based on the past history of inflation and past inflation forecast errors: EQUATION 21.1

Rational expectations involves predicting inflation based on available information, usually processed through some formal economic model: EQUATION 21.4

The choice of expectations models influences predictions about the neutrality and potency of monetary policy actions

The Key EquationsThe Algebra of Adaptive Expectations

The Algebra of Rational Expectations

Adaptive Expectations: A Numerical Example

Year Pt Forecast for Pt

Forecast error

2006 100 100 0

2007 110 100 10

2008 115 105 10

2009 125 110 15

2010 140 117.5 22.5

Rules Versus Discretion in Monetary Policy

The Phillips Curve suggests a temptation by policy makers to exploit the trade-off between inflation and unemployment

Phillips Curves in the Short Run and the Long Run

•3 = e3

D

e3

C•u*

•

Inflation rate, actual ( ) and expected (e)

A1 = e1

Long-run Phillips curve

Short-run Phillips curves

e1

•B

2 = e2

e2

Rules Versus Discretion in Monetary Policy

As a result, there is thought to be a built-in bias toward more inflation than is desirable. This is called the time inconsistency problem

Credibility in monetary policy is central to its success or failure

A New Trade-Off: Taylor’s Rule

Variance of Inflation

Variance of the output gap

B

AStrict inflationtargeting

Flexibleinflation targeting

Strict output gaptargeting

Base Drift

Monetary targeting is one way to implement a monetary policy rule and has been used in many countries

Revisions of the target, which can be frequent, means that the new target growth rate ins in terms of some new base value, not the original base value when the policy was introduced

As a result, the base used to target money growth drifts over time: TABLE 21.2

A Numerical Example of Base Drift

Year Target Actual Revised Target

Base drift

1 103 104 - -

2 106.1 108.2 107.1 1

3 109.3 112.5 111.4 2.1

4 112.6 117 115.9 3.3

5 116 121.7 120.5 4.5

Theories of Money

The Quantity Theory has existed for centuries in one form or another and essentially links changes in the price level to changes in the money supply:MV=Py

The link between M and P is clearest if we assume that income and velocity of circulation (Chapter 12) are constant

The real bills doctrine is also an old idea recently re-introduced. It suggests that fluctuations in the price level can be determined by looking at the balance sheet of the central bank and how its assets are backed

The Transmission of Monetary Policy

The central problem in monetary analysis is understanding how money supply changes are transmitted to the real side of the economy

As a result, it is important to consider the transmission mechanism in monetary policy. But which one? Interest rate channel: as in loanable funds theory exchange rate channel: as in interest rate parity asset price channel: as in Tobin’s q credit channel: via banking system portfolio

management

Money and Growth

Is inflation harmful to economic growth? Inflation leads to costly and wasteful

activity but is it significant? The evidence is mixed: FIGURE 21.3

Inflation and Economic Growth

Summary

The debate about the role of money centers on how important money supply changes are in explaining economic activity

Monetarists place emphasis on fluctuations in the money supply to explain inflation and economic growth

There is a temptation for monetary authorities to inflate called the time inconsistency problem

The Phillips curve is the principal model used to analyze the role of monetary policy