Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2007

Study Guide for Third Test

The third test is scheduled for Wednesday, May 9^th from 10:30am to 12:30pm (although you should not need the entire two hours). As the third test, it includes the material from chapters 11 & 12 in Handa, the Federal Reserve policy web-linked pages (from the FRS and the SF FRB on the course syllabus and at the course web-site in the Policy Unit), 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 (and some potential test questions in italics).

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. Other concerns or requirements are that the variables subject to the policy goals need to be measurable in a timely manner, as well as have a theoretical and empirical relationship to the FED’s tools or instruments. Further, because the goal variables are likely to be influenced by other macroeconomic phenomena, the FED has to know (predict?) and account for effects these other forces will have.

· 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.

There were multiple problems with this strategy. It presumed the Phillips’ curve trade-off (inverse relationship between unemployment and inflation) was a long-run relationship. More recent theory and evidence establishes that the long-run Phillips’ curve is vertical; that is, there is no trade-off. Further, attempts to push the unemployment rate below the natural rate create an accelerating rate of inflation; thus, as the natural rate of unemployment began to rise during the 1970s, the policies to reduce the actual unemployment rate had a bias to create additional inflation. As well, the underlying macroeconomic model of the period assumed the business cycle phenomena were the result of AD curve shifts – the primary exogenous macroeconomic disturbances of the 1970s are perhaps best understood and modeled as AS curve (or price) shocks.

· 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. Also, consider the origin of the macroeconomic disturbances prior to the 1970s and 1980s, during those two decades, and subsequent to them – were they AD or AS shocks, and what are the appropriate operating targets and strategies under those different circumstances?

· 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 – far 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.

See also the four-part document (Economic Letter, 2004) from the San Francisco Federal Reserve Bank – it provides more discussion and explanation of the material and topics addressed in chapters 11 & 12 in Handa.

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 is a test question I have 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.