what should central banks do? monetary policy goals ...syeda/ec3313/ch16.pdf · chapter 16 what...
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Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-2
The Price Stability Goal
• Low and stable inflation• Inflation
Creates uncertainty and difficulty inplanning for futureLowers economic growthStrains social fabric
• Nominal anchor• Time-inconsistency problem
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-3
Other Goals of Monetary Policy
• High employment
• Economic growth
• Stability of financial markets
• Interest-rate stability
• Foreign exchange market stability
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Should Price Stability be thePrimary Goal?
• In the long run there is no conflict between the goals
• In the short run it can conflict withthe goals of high employment and interest-rate stability
• Hierarchical mandate
• Dual mandate
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Monetary Targeting
• Flexible, transparent, accountable
• AdvantagesAlmost immediate signals help fix inflation expectations and produce less inflationAlmost immediate accountability
• DisadvantagesMust be a strong and reliable relationshipbetween the goal variable and the targeted monetary aggregate
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Inflation Targeting I
• Public announcement of medium-term numerical target for inflation
• Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal
• Information-inclusive approach in which many variables are used in making decisions
• Increased transparency of the strategy• Increased accountability of the central bank
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-7
Inflation Targeting II
• AdvantagesDoes not rely on one variable to achieve targetEasily understoodReduces potential of falling intime-inconsistency trapStresses transparency and accountability
• DisadvantagesDelayed signalingToo much rigidityPotential for increased output fluctuationsLow economic growth during disinflation
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-11
Implicit Nominal Anchor
• Forward looking and preemptive• Advantages
Uses many sources of informationAvoids time-inconsistency problemDemonstrated success
• DisadvantagesLack of transparency and accountabilityStrong dependence on the preferences, skills, and trustworthiness of individuals in chargeInconsistent with democratic principles
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-13
Tactics: Choosing the Policy Instrument
• ToolsOpen market operationReserve requirementsDiscount rate
• Policy instrument (operating instrument)Reserve aggregatesInterest ratesMay be linked to an intermediate target
• Interest-rate and aggregate targets are incompatible
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16-16
Criteria for Choosing the Policy Instrument
• Observability and Measurability• Controllability• Predictable effect on Goals
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The Taylor Rule, NAIRU, and the Phillips Curve
Federal funds rate target =inflation rate+ equilibrium real fed funds rate
+1/2 (inflation gap)+1/2 (output gap)
• An inflation gap and an output gapStabilizing real output is an important concernOutput gap is an indicator of future inflation as shown by Phillips curve
• NAIRURate of unemployment at which there is no tendency for inflation to change