Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2004

Study Guide for Third Test

The third test during the final exam period on Thursday, May 6^th from 5pm to 7pm will include the material from chapters 14 (shifted from the previous unit), 11, & 12 in Handa, the Federal Reserve policy web-linked pages (on the course syllabus and at the course web-site), and the St. Louis FRB article by Gilbert. The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in Handa. See/study the appropriate chapter sections of the text for details. I have inserted annotations in italics.

Chapter 14 – Keynesian and Neo-Keynesian Approaches

Keynes and his subsequent followers had different assumptions about the structure and processes of the macro-economy than the classical and neo-classical approaches; thus, they reach different conclusions and results.

• Early (1940s and 1950s) Keynesian models were based on nominal wage rigidity or price illusion by labor.
• In the 1960s and 1970s, Keynesian models were often based on the Phillips curve.

The Phillips’ curve is, of course, the inverse relationship between the inflation rate and unemployment rate. The classical and neo-classical views hold that such a relationship might exist only in the short-run; in the long-run the Phillips’ curve is vertical. Why?

• More modern versions of such (Keynesian) models rely on staggered wage contracts with price expectations and the possibility of expectational errors.

Hence, the inflation-expectations augmented short-run Phillips’ curve can be derived and applied.

• An abiding theme in Keynesian models, originating with Keynes’ The General Theory, is the failure of the economy to attain Walrasian general equilibrium. This is attributed to the absence in the real world of an adequate coordinating mechanism such as tatonnement, auctioneer or recontracting, and the imperfect functioning of the competitive mechanisms that do exist in the modern economy. The Keynesian approach asserts that this failure is especially symptomatic of the labor market, so that involuntary unemployment is a common occurrence in the real-world economies.

How is this different from the classical or neo-classical approach? From the modern or new classical approaches?

• The Keynesian model based on this deficiency in the macroeconomic environment is the demand-deficient model. This approach posits that the rational dynamic responses by firms and households to conditions of inadequate demand and involuntary unemployment do not always take the economy to full employment or do so within the acceptable period.

Why not? That is, why don’t these rational dynamic responses take the economy to full employment (or within an acceptable period)?

• The demand-deficient models imply that the responses of output and unemployment with respect to changes in the money supply during periods of demand deficiency are not properly captured in the Phillips curve or the Lucas supply curve relationships.
• The neo-Keynesian theories rely on rational long-run behavior resulting in implicit contracts, staggered wage contracts, sticky prices and menu costs, etc.

Notice here that Handa is presenting and discussing a long-run view – how does this neo-Keynesian view differ from a neo-classical view in not only the assumptions, but also the conclusions?

• There is no logical inconsistency between the Keynesian approach and rational expectations. Further, Keynes’ The General Theory argued strongly for the adequate consideration of both short-run and long-run expectations in the macroeconomic analysis. The Keynesian models can quite legitimately incorporate rational expectations, provided they are defined in a manner consistent with the economy’s effective state – which need not necessarily be the general equilibrium one.
• There is no logical inconsistency between the Keynesian approach and Ricardian equivalence. While incorporation of Ricardian equivalence into the Keynesian models renders fiscal policy ineffective, it enhances the role of monetary policy in stabilizing the economy.

What is Ricardian equivalence? (See Handa 13.17.)

• However, the spirit both of Keynes’ The General Theory and of Keynesian analyses, as well as their policy conclusions, runs counter to Ricardian equivalence. Therefore, while the Keynesian models can be modified to incorporate Ricardian equivalence, doing so is not consistent with the spirit of the Keynesian tradition.

What is the spirit of Keynes’ General Theory, Keynesian analyses, and their policy conclusions? How do these compare with the “spirit” of classical, neo-classical, monetarist, modern classical, and/or new classical views? What specifically accounts for the difference(s) or similarity?

Chapter 11 – The Central Bank: Goals, Tools and Guides for Monetary Policy

Because the FED has only the ability to influence (and not directly control) the money supply through the use of its policy tools, the policy process is a bit more complex than heretofore presented. The FED uses its policy tools to directly affect operating target variables which, in turn, affect intermediate target variables which are then related to the ultimate policy goal variables. This requires setting policy goals, understanding and applying the theoretical and empirical relationships among the goal, intermediate, and operating variables, and appropriately using the policy tools.

As well, one should see that the macroeconomic processes are affected by many things outside of the FED’s control – which can make policy-making very difficult. And there is, of course, the problem of “politics” in a democratic society where priorities in goal-setting can be quite contentious.

· Historically, most central banks have had the mandate to pursue a number of macroeconomic goals, including price stability, low unemployment, high growth, etc. Achievement of multiple goals is only possible if the economy allows such a possibility and the policy maker has enough policy tools.

That is, to achieve multiple goals either the goals need to be consistent with each other and/or you need to have a sufficient number of policy tools to achieve the multiple goals (at least one tool per goal). The FED really has only one tool – an ability to affect the supply of reserves through either open market operations or the discount rate.

· In the 1960s and early 1970s, economic theory implied, and most central banks attempted to achieve, a tradeoff based on the Phillips curve between unemployment and inflation. This tradeoff proved to be unstable for policy and was abandoned by the 1980s.

· In the 1990s, many economists have recommended, and the central banks have generally followed, the goal of price stability – translated as a low rate of inflation – for monetary policy. There is a corresponding abandonment, or relegation to a subsidiary role, of the objective of maintaining a low unemployment rate.

It may be fair to say that while monetary policy is recognized as having non-neutral effects in the short-run, the long-run neutrality of money largely requires monetary policy to give priority to achieving the long-run goal of price stability.

· While the interest rate was historically the operating target of monetary policy, a diversion to monetary targeting occurred during the late 1970s under the impact of St. Louis monetarism. This experiment was not considered to be a success in most countries, and the most common operational target again became interest rates.

See the Gilbert article on FED operating procedures in the 1970s and 1980s.

· Most Western countries have reduced percentage reserve requirements on commercial banks to levels that are close to zero. Changes in these requirements have ceased to be a tool of monetary policy.

Not only for this reason are they not a normal tool of policy, but in the past when reserve requirements were higher or in force, they had potential to be an exceptionally powerful tool – too powerful for the typical magnitudes of necessary monetary policy adjustment. (My “sledgehammer-to-drive-thumbtacks” analogy.)

· In the 1990s, the most common tools of monetary policy in developed economies are change in interest rates and open market operations.

Chapter 12 – The Central Bank: Targets, Conflicts, Independence and the Time Consistency of Policies

· If the economy does allow short-run tradeoffs among multiple goals, there is a high potential for periodic conflicts among policy makers in the goals attempted and the policies pursued.

· If the economy does not allow monetary policy to affect output and unemployment even in the short run – that is, money is neutral – the adoption of price stability as the single or dominant monetary policy goal becomes more clearly the optimal policy goal for the nation. It also reduces the potential for conflicts between monetary and fiscal policies.

The following three items are in reference to selection of intermediate targets for monetary policy:

· While adoption of the goal of price stability lowers the inflation rate and its variability, it also increases the fluctuations in output and unemployment under supply shocks.

If the FED is trying to keep the price level stable (a non-accommodative policy) as the economy is subject to supply (or price) shocks, that policy creates greater fluctuations in output and employment. They could stabilize output with an accommodative policy, but then the inflation rate would become volatile.

· Successful interest rate targeting, in comparison with monetary targeting, increases the impact on aggregate demand of investment, net exports, fiscal deficits and other disturbances in the commodity markets while eliminating the impact of shocks emanating from the financial sectors.

If the FED is targeting interest rates, then they are in effect creating a flat/horizontal LM curve. As the goods (commodity) market disturbances arise from consumption, investment, net exports, or fiscal sources and the IS curve fluctuates, you will get bigger changes in AD – that is, targeting interest rates provide pro-cyclical reinforcement to goods market disturbances. On the other hand, targeting interest rates isolates monetary and financial shocks from the real economy – an example of counter-cyclical stabilization (if the LM curve would shift one way, use monetary policy to counter or offset that shift and keep it at the same interest rate intersection with the IS curve).

· Monetary targeting eliminates the impact of fluctuations in the money supply induced by the private sector and moderates the impact of fluctuations emanating from the commodity market.

If the FED is targeting the money stock, then goods market disturbances are mitigated (limited) – it’s a counter-cyclical policy. In effect, such a money stock targeting policy makes the LM curve steeper. But the down-side is that if the disturbances are coming from the money or financial markets, this targeting policy is pro-cyclical.

· Central bank independence has been found to reduce the rate of inflation.

Why? If the central bank is independent of the government (fiscal authorities), then the central bank is in a stronger position to fight inflation – it can deny financing (purchasing government debt – bonds) when the government wants to run a deficit (or does not have the political will to cut spending or raise taxes). If it has less independence, then it might have to buy the debt – bonds created to finance the fiscal deficit, which would make the deficit fiscal policy more inflationary (the money stock increases in addition to the fiscal stimulus).

· The credibility of the central bank is essential to the successful reduction of inflation rates by it. Credibility is also a factor in reducing the time lags in the adjustment of the expected inflation rate and of the actual inflation rate.

Time lags in policy can be a big problem – there are lags in 1) getting information and recognizing the problem, 2) making a policy decision, 3) implementing the decision, and then 4) waiting for the economic impact to work its way through the economy (the impact lag). Monetary policy tends to have shorter lags in the earlier three steps (compared to fiscal policy) – the impact lag of monetary policy has been characterized as “long and variable”. On the other hand, fiscal policy tends to have longer lags in the earlier three steps, but a much shorter impact lag.

· The pursuit of time-consistent monetary policies buttresses the central bank’s credibility. Whether such policies prove to be superior to discretionary ones depends on the nature of the shocks and whether they were anticipated.

· The credibility of a policy committed to keeping the price level stable imposes realism on the goals of monetary policy. In the analysis of this chapter, it requires that the central bank not try to achieve a target output higher than the full employment one.

The 1985 Gilbert article from the St. Louis FRB

You should be able to articulate each of the three different operating procedures presented in the article. That is, explain how each operating procedure fit into the process of achieving the appropriate intermediate target (interest rates or money stock), how each procedure was implemented to achieve the operating target, and the consequences for interest rate and/or money stock fluctuations.

Here’s the test question I’ve used in the past (stochastic means unpredictable, random):

Gilbert's article (StLFRB's Economic Review) presents and explains monetary policy operating procedures under three different regimes:

1) targeting the federal funds rate, such as was done during the 1970s (and since the mid-/late-1980s to the present);

2) targeting non-borrowed reserves, as was done between October 1979 and October 1982; and

3) targeting borrowed reserves, as was done from October 1982 until the mid- / late-1980s.

Select ONE of these three procedures and explain how it is used to achieve control of the intermediate target of money stock growth. Clearly identify the theoretical framework for the procedure, the steps in the operating procedure in responding to a stochastic increase in money (reserve) demand, and the advantages and disadvantages in the procedure.