Chapter 21 Conduct of Monetary Policy

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Chapter 21Conduct of Monetary Policy
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Official Goals for Monetary Policy

• By law, the Fed is supposed to seek
• Stable prices
• High employment
• High output
• Rapid economic growth
• But monetary policy cant on average raise
• Employment
• Output
• The growth rate
• So the Feds actual and official goals must
  differ.

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Actual Goals of Monetary Policy

• The Fed has three primary goals
• A low but positive inflation rate (its
  interpretation of stable prices)
• A low variance of the inflation rate p around its
  target p
• A low variance of log output y around its
  long-run growth path y

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Feds Primary Goals in Symbols

• Economists model the Fed as minimizing
• w var(pp) (1w)var(yy)
• 0 lt w lt 1
• A larger w means that the Fed is relatively
• More concerned about deviations of the inflation
  rate from its target
• Less concerned about deviations of output from
  its growth path

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Financial Stability

• The Fed is also a central actor in the financial
  markets.
• It seeks to accomplish its primary goals without
  disrupting financial markets.
• So it usually makes gradual and infrequent
  changes in its target funds rate.

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Lender of Last Resorts

• Liquid financial markets are essential for the
  Fed to achieve its goals.
• Congress has given it powerful tools for serving
  as a lender of last resorts.
• During the liquidity crisis, the Fed has
  interpreted its powers very broadly and
  creatively, lending not only to sound banks but
  also to a wide spectrum of sound financial firms.
• In a few case, it has even lent to unsound firms
  that would otherwise have gone bankrupt.

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Foreign-Exchange Markets

• The foreign-exchange markets rarely, if ever,
  affect what the Fed does.
• Its unstated policy is one of benign neglect.
• In other words, it lets the dollar freely float.

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Major Problems

• It is difficult for the Fed to achieve its
  primary goals for two reasons
• Information lags. Typically, six months must pass
  before it can identify the need to change policy.
• Lags in effect or impact lags. Long lags exist
  between when it takes an action and when the
  action has appreciable effects.

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Case Study Information Lags

• The US economy began to weaken markedly in May
  2000.
• Industrial production and employment began to
  decline in May and continued to do so for the
  next two years.
• The Fed continued to fight inflation by keeping
  the funds rate high indeed, by increasing it
  some more.
• It changed direction only in December 2000.
• The recession began officially in January 2001.

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Lags in Effect

• About six months must pass before a change in the
  funds rate affects output, and the peak effect
  takes about 18 months.
• The lags for inflation are even longer
• A year before any effect occurs
• Two to four years before the peak effect occurs.

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How the Fed ShouldSet the Funds Rate

• John Taylor is a well-known economist who teaches
  at Stanford and has worked in both Bush
  Administrations.
• He has proposed that the Fed set the funds rate
  iff according to the rule
• iff a p b(pp) c(yy)
• a, b and c are coefficients, which in his example
  were a 2 and b c 0.5 but might be set as
  some other positive numbers.

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Explanation of the Taylor Rule

• Suppose that the inflation rate increases above
  its target. What should the Fed do if it wishes
  to bring the inflation rate back down?
• Answer It must raise the real funds rate to
  restrain spending.
• To increase the real funds rate, it must increase
  the nominal funds rate by more than the inflation
  rate increases since
• r i pe

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Taylor Principle

• So b must be positive in
• iff a p b(pp) c(yy)
• If b were negative, the real funds rate would
  decline, stimulating spending and fueling
  inflation still more.
• The idea that the nominal funds rate should move
  more than one-for-one with the inflation rate is
  called the Taylor Principle.

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Output

• Suppose that the economy falls into a recession
  i.e., yy becomes negative. What should the Fed
  do to push yy back toward zero?
• Answer The Fed should reduce the real and
  nominal funds rate in order to stimulate
  spending.
• So c should be positive in
• iff a p b(pp) c(yy).

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What the Fed Actually Does

• The Taylor Rule is not merely a plausible policy
  for the Fed to follow but also what it has
  approximately done since at least 1960.
• Specifically,
• 1960-1979 iff 1.0 p .3(p3.5) 1(yy)
• 1980-1998 iff 2.2 p .7(p1.5) .3(yy)
• Note that b lt 0 in the period 1960-1979.

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Importance of b gt 0

• b lt 0
• Real interest rate falls when inflation rises
• Result Instability
• b gt 0
• Real interest rate rises when inflation rises
• Result Stability
• Fact b lt 0 before 1980 b gt 0 since then

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Instability

• Many economists think that in the period
  1960-1979 the inflation rate was high and output
  was unusually volatile because the Fed did not
  then respect the Taylor Principle i.e., b was
  negative.
• Many other countries also had this problem.
• We conclude with plots that provide some evidence
  for this view.

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Other Countries

• Many other countries did not respect Taylors
  Principle before the 1980s and did so afterwards.
• Those countries also had high inflation rates and
  unstable GDP before the 1980s and lower inflation
  rates and more stable GPD afterwards.