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EC3332 Lecture 7-11 Summary
EC3332 Lecture 7-11 Summary
Conventional tools of monetary policy & its effect on federal funds rate
(a) open market operations (OMO)
if intersection is at
the flat area
vs
downward-sloping
vs
horizontal
vs
downward-sloping
Hierarchical mandate: put the goal of price stability first, and then say that as
long as it is achieved other goals can be pursued
Dual mandates: aimed to achieve two coequal objectives
Primary, long-run goal of monetary policy: price stability
Either type of mandate is acceptable as long as it operates to make price
stability the primary goal in the LR, but not the SR
Inflation-targeting
Recognition of price-stability as primary long-run goal of monetary policy has
led to monetary policy strategy known as inflation targeting
Involves 5 key elements:
(a) public announcement of medium-term numerical target for inflation
(b) institutional commitment to price stability as the primary, long-run
goal of monetary policy & a commitment to achieve the inflation goal
(c) information-inclusive approach in which many variables are used in
making decisions
(d) increased transparency of the strategy through communication with
public and financial markets
(e) Increased accountability of the CB for attaining its inflation objectives
e.g.,
New Zealand (1990)
Inflation was brought down & remained within the target most of the
time
Growth has generally been high & unemployment has come down
significantly
Canada (1991)
Inflation decreased since then, some costs in terms of unemployment
United Kingdom (1992)
Inflation has been close to its target
Growth has been strong & unemployment decreasing
Advantages of inflation-targeting
(1) reduces potential of falling in time-inconsistency trap
(2) highly transparent & easily understood by the public
(3) Increased accountability of the CB
Disadvantages of inflation-targeting
(1) Delayed signaling as lag effects of monetary policy imply hat
outcomes are only revealed after substantial lags
(2) Too much rigidity which restricts monetary policymakers in responding
to unforeseen circumstances
(3) Potential for increased output fluctuations as sole focus on inflation
may lead to overly tight monetary policy
(4) Low economic growth even when low inflation is already achieved
The Feds monetary policy strategy: Just Do IT
The fed does not use an explicit anchor such as an inflation target
Feds strategy involves an implicit nominal anchor in the form of an
overriding concern to control inflation in the LR (commitment to price
stability both in the SR and LR)
Forward-looking behaviour which involves close monitoring of signs of
future inflation & periodic preemptive strikes of monetary policy
against the threat of inflation
The goal is to prevent inflation from getting started hence, monetary
policy needs to be forward-looking and preemptive
Advantages of the Feds approach
Uses many sources of information to determine the best settings for
monetary policy
Forward-looking behaviour & stress on price stability help to
discourage overly expansionary monetary policy thereby reducing the
time-inconsistency problem
Disadvantages of the Feds approach
Lack of transparency tends to generate a high level of uncertainty thus
leading to volatility in financial markets
Heavy dependence on the preferences, skills and trustworthiness of
the individuals in charge of the CB
Tactics: choosing the policy instrument
Central bank directly controls the three tools of monetary policy
(1) Open market operations
(2) Reserve requirements
(3) Discount rate
To examine whether monetary policy is easy or tight, we can observe the
policy instrument (operating instrument)
Policy instrument is a variable that responds to the CBs tool and
indicates the stance (easy or tight) of monetary policy
(4) Lecture 8: Quantity theory, inflation and demand for money & the
monetary policy & aggregate demand curves
Quantity theory of money
MV = PY
Assumptions: V and Y are constant, thus change in price is determined solely
by quantity of money
When the market money is in equilibrium, Md = M,
Md = (1/V) x PY
Since 1/V is constant, the level of transactions generated by a fixed level of
PY determines Md
Thus, Md not affected by interest rate (according to Fishers model)
! The amount of money each individual decides to hold is independent of
interest rate
budget deficits & inflation
Budget deficit = G (gov. expenditure) T (tax revenue) = MB + B
How the government may finance a budget deficit:
(1) raise revenue through: levying taxes
(2) borrowing through selling government bonds
(3) creating money (printing?
Reveals two important facts:
(1) if government deficit is financed by increased bond holdings by the
public, increase in B, no MB ! no change in money supply
(2) if government deficit is financed otherwise, increase in MB ! change
in money supply (increase)
hyperinflation
periods of extremely high inflation (>50%/month)
arises when governments print money to finance their budget deficit
e.g., Zimbabwe in 2007 with hyperinflation of 1,500%
Keynesian theories of money demand
Keynes liquidity preference theory, abandoning the quantity theory view that
velocity was constant
Why do individuals hold money?
(1) transactions motive (medium of exchange)
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under the quantity theory of money ! interest rates do not affect money
demand ! velocity is constant
however, the more sensitive money demand is to interest rates, the more
unpredictable velocity will be
stability of money demand
Keynes believed that the money demand function is unstable & undergoes
substantial unpredictable shifts
rapid pace of financial innovation since 1970s ! substantial instability
velocity is not constant ! unpredictable
hence, quantity theory of money may not hold
*crucial to whether the Fed should:
(1) target interest rates or
(2) money supply (however, this is very much dependent on the stability of
money demand)
hence, the Fed typically targets the interest rate, and has downgraded its
focus on money supply in its conduct of monetary policy since the level of
interest rates provide more information about the stance of monetary policy
than the money supply
federal reserve & monetary policy
the Fed conducts monetary policy by setting the federal funds rate (the
interest rate at which banks lend to each other)
when the Fed lowers the ff rate, real interest rates fall
when the Fed raises the ff rate, real interest rates rise
monetary policy curve:
r = autonomous component of r + (responsiveness of r to inflation) x
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Curve shows how monetary policy, measured by the real interest rate, reacts
to the inflation rate,
Taylor principle: upward-sloping monetary policy curve
Key reason: central banks seek to keep inflation stable
Taylor principle: nominal interest rates must rise when expected inflation
rises, so r rises when rises
If a bank allows r to fall when rises, then:
rises (while r falls due to non-intervention) ! AD rises ! rises some more
(still no intervention in r) ! AD rises some more ! worsening inflation
two types of monetary policy action that affects interest rates
(1) automatic (taylor principle) changes ! movements along the MP curve
(2) autonomous changes ! shifts of the MP curve
autonomous tightening of monetary policy (contractionary) that shifts
MP upward (in order to reduce inflation)
autonomous easing of monetary policy (expansionary) that shifts MP
downward (in order to stimulate the economy)
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Response to an AD shock
CB can respond to this shock in two possible ways:
(1) no policy response
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policy
makers
pursuing
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If bank is not credible: then e will rise as the public is unsure whether action
will be taken to drive AD back down, thus resulting in SRAS shifting up,
rises.
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If the bank is not credible: the public will see an easing of monetary policy to
increase AD as the central bank losing its commitment to the nominal anchor
! will pursue inflationary policy in the future ! e rises ! SRAS shifts left
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If the credibility of the nominal anchor is weak (not credible), e will rise, so
the upward shift of SRAS will be large, resulting in even higher inflation and
lower output
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The public will then expect that the conservative central banker
will be less tempted to pursue expansionary monetary policy and
will try to keep inflation under control
Hence inflation expectations will be held down at low levels with
actual (realized) inflation remaining low in the long run.
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(3) Weakens the value of exchange rate as a signal for monetary policy
Under a floating exchange rate regime, the exchange rate will
depreciate in response to overly-expansionary monetary policy
! early warning signal
However, exchange rate targeting fixes the exchange rate thus
making it hard to ascertain the central banks policy actions.
Public is less able to keep watch on the central banks stance on
monetary policy ! monetary policy more likely to be overlyexpansionary
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