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The Conduct of Monetary Policy and Strategy
The Conduct of Monetary Policy and Strategy
Overly expansionary High Inflation Reduced Economic Efficiency Lower Growth Levels
Have a discretionary Monetary Policy More expansionary than people and firms expect
Role of Expectations
Decisions about Reflect about workers and firms’ Higher expectations But not much increase
wages and prices expectations about inflation lead to higher inflation in output on an average
Not to have an expansionary Monetary Policy?
Discretionary Monetary Policy
Firms & workers raise their expectations about inflation
Becomes more Expansionary
So, better to have long-term perspective and avoid
unexpected expansionary MP
Such as inflation rate or That ties down price level Price stability Promotes low and stable inflation expectations
MS
Brazil Russia
Price stability Goal becomes one of the most important goals of any monetary policy. What else?
CONFLICT OF GOALS
1. High Employment and Output Stability
Say, a situation of high unemployment – idle workers – loss of output – fall in GDP
Unemployment > 0
Natural Rate of Output – Potential Output – potential GDP – Maximum Rate of Employment
Tax incentives
If the currency ($) rises – market becomes less competitive if it falls, can stimulate inflation in the country
There is conflict between goals and price There is no tradeoff between inflation and
stability, the importance of price stability can employment. In long run, thus if price
conflict with the goal of output stability and stability is achieved, it does produce output
growth and promotes stable int rates and fin stability
Conflict of Goals
Lower unemployment So, the interest rates are unstable
Dual Mandate
If output is kept stable, over a period of time - there will be long-term consequences of inflation.
Since price stability is preferred, even in short run - output fluctuations are tolerated.
Monetary targeting
Inflation targeting
India Inflation Targeting
Federal Reserve - “just do it”
- No formal anchor
- Transparent
- Preemptive forward looking policy
- No inflation targeting till 2012 (achieved low
inflation and good growth)
- No accountability
- No predetermined criteria
Ideal Goals
1. Development in financial sector has a far greater impact on economic activity than we ever
realised. Financial frictions have important role in fluctuations in business cycles
2. Zero bound on interest rates can be a serious problem. Such a rate can force the central bank to
use unconventional policy tools which are harder to use effectively and have uncertain impacts
3. High cost of clearing up after financial crisis. Higher unemployment caused by deep recessions
higher debts can be difficult and costly to correct.
Using stability mechanisms the Federal Reserve Bank did achieve “Great Moderation”
But still financial stability was not attained .. in fact can we say that it may have promoted it?
How?
Low volatility of inflation and low output fluctuations may also result in ….Crisis?
1. Level of the Inflation Target - is inflation target too low if the int rate is zero bound? Kept inf target
at 2% and lower bound int rate is almost zero.
If say only by keeping int rate at 0, you get benefit from a higher inflation target
If say by influencing the nominal interest rate, there is more scope for expansionary policy
However, there are other costs to increase inflation – it is difficult to stabilize inflation at 4%, if 4% then 6% and … 8%
Difficulty of containing at 4%
2. Flexibility of Inflation Targeting - to allow some short run deviations of inflation from the target - so
that - output stability and overall price stability can be achieved
Advantages of Inflation Targeting
1. Reduction of time inconsistency problem - it is less likely that the CB falls in the time inconsistency
trap of trying to expand output and employment in the short run. Reduce political pressure -
economic growth and employment through monetary policy.
2. Increased Transparency - policy making, communication with governments, information to public,
publish documents. Such reports help reduce uncertainties and improve planning and investment
decisions. Clarify responsibilities.
3. Increased Accountability - predefined and pre-announced targets, well defined targets as we saw in
case of new zealand bank.
4. Consistency with Democratic Principles - since central bank should have complete control over
operational decisions and so can be held accountable for achieving assigned objectives.
5. Improved Performance - inflation targeting has worked well for economies. Reduced inflation rate
and inflation expectations which have stayed low.
Disadvantages of Inflation Targeting
1. Delayed signaling - at times the target may not immediately signal to the public and market - due to
time lag. So, not easy to control. Inflation as a outcome of monetary policy is revealed after
substantial lag.
2. Too rigid? Maybe not. Since useful policy strategies exist that involve forward looking behaviour -
that means - no undesirable behaviour with long run consequences. Using all information to decide
which policy is appropriate to achieve inflation target - use of discretion - modify if required - leave
considerable scope to achieve inflation target.
3. Potential for higher output fluctuations? No. inflation targeting may not necessarily mean one
target. The reason why they choose a 2 - 2.5% inf target and > 0, is that deflation does not have
negative consequences on economic activity - such deflations can lead to economic contractions -
Bank of Japan - finally targeting at inflation around 2%
4. Low economic growth - once low inflation is achieved, output recovers and it is not harmful to real
economy. Therefore, In addition to controlling inflation, it will promote real economic growth.
Should Central Banks try to Stop Asset Price Bubble
● Costly
So, any policy to control it? ● Brings down financial systems
● Economic downturn
Any policy to break the bubble? ● Unemployment
● Hardship increases
Driven by credit –
then market crashed and credit reduced – prices fell further – lower spendings – lower incomes
the tech bubble of 1990 – driven by expectations – milder and less impact on economy
So, whether or why should the central bank correct the bubble?
The debate is not whether the central bank should respond at all, it is how much/ or to what extent
to respond
“Lean vs Clean” debate
What policy can stem the negative impacts of exuberance driven bubbles?
Any policy can work under a system of an excellent foundation in the form of REGULATION
Risk taking channel of Monetary Policy
Supervision
All regulatory policies
Countercyclical
Macroprudential
2 1
regulator
Adjust upward Adjust downward
BOOM BUST
● Compliance requirements
● High credit standards
* overly easy Monetary Policy, promotes instability, lower interest rate leads to excessive risk taking
Tactics: Choosing the Policy Instrument
● OMO
● RR
Easy? OR ● DR
● IOR
Tight? ● LSAPS
Policy Instrument ● FG
Intermediate target
Tools Goals
Say, nominal GDP growth rate of 5% (Goal) – can be achieved by a 4% growth rate for M2 (intermediate target) – which
will in turn be achieved by a 3% growth rate of NBR (policy instrument) – set the FFR (a policy instrument) at 4%
A central bank can choose to target both the NBR and the FFR policy instrument at the same time? NO.
Taylor Rule – John Taylor: the monetary authority should raise nominal interest rate by more than
increase in the inflation rate – Taylor principle
(If the rise in nominal int rate is less than the inflation rate, the real int rate falls when inflation rises)
target for inflation of 2% , suppose the inflation rate is 3% – positive inflation gap of 1%
https://www.cmegroup.com/openmarkets/economics/2022/Assessing-Monetary-Policy-Through-The-Taylo
r-Rule.html