Chapter 16: What shouldd central banks do? Monetary policy goals, strategy and tactics

The price stability goal and the nominal anchor
-price stability: low and stable inflation; high inflation = lower economic growth; creates uncertainty

1. The role of a nominal anchor
-a nominal variable such as inflation rate or the money supply ties down price level to achieve price stability; adherence to nominal anchor promotes low inflation
-limits time-inconsistency problem

2. The time-inconsistency problem
-tempted to pursue discretionary monetary policy that is more expansionary than expected becauses boost economic output in the short run
-best policy is not to purue expansionary policy because decisions about wages and prices relect workers' and firms' expectations about policy; when they see an expansionary policy, they expect inflation driving wages and prices up --> higher inflation but not higher output
-best policy is to keep inflation under control
-nominal anchor is a behavior rule; prevent the time-inconsistency problem in monetary policy by providing an expected constraint on discretionary policy.;

Other goals of monetary policy
1. Higher employment: the alternative situation: high unemployment causes misery; high ue = idle workers and resources = loss of output
-frictional ue: searches to find suitable matchups; beneficial to economy
-structural ue: mismatch between job requirements and skills or availability of local workers; undesirable
-natural rate of ue: demand for labor equals the supply of labor

2. Economic growth
-related to high employment;encouraging firms to invest or encouraging people to save
-supply-side economics polcies: intended to spur economic growth by tax incentives for businesses to invest and for taxpayers to save.

3. Stability of financial markets

4. Interest rate stability
-fluct can create uncertainty
-reduce upward movements: generate hostility toward central banks and lead to demands that their power be curtailed
-increase in interest rate: large capital losses on long-term bonds and mortgages

5. Stability in foreign exchange markets
-rise in value eof dollar makes american industries less competitive; declines in value stimulate inflation in us.

Should price stability be the primary goal of monetary policy?
1. in long-run, no trade-off between price stability and other goals
-short run price stability conflicts with goals of high employment and interest-rate stability

2. Hierachical vs. dual mandates
-hierachical mandates: primary goal is price stability then other goals
dual mandate: price stability and max employment
-price stability should be the primary, long-run goal of monetary policy

Monetary targeting
1. central bank announces certain vaule of annual growth rate of a monetary agggregate such as 5% growth rate of M1 or 6% growth rate of m2.
2. US: kept missing target
-shocks that made monetary aggregates control difficult
-smokescreen: free to manipulate interest rates to dampen inflation; won't be blame for high interest rates
no longer use monetary aggregates as guide for monetary policy

3. Germany: success
-focus on narrow monetary aggregate called central bank money: sum of currency in circulation and bank deposits
-more transparent to the public; not rigid; more accountable

4. Advantages of monetary targetiing
-info on whether central bank is achieving its target is known immediately; fix inflation expectations and produce less inflation
-allow immediate accountability for monetary policy to keep inflation low --> help precent from falling into the time-inconsistency trap

5. Disadvantage sof monetary targeting
-there must be strong and reliable relationship between goal variable (inflation or nominal income) and the targeted monetary aggregate

Inflation targeting
1. public announcement of medium-term numerical targets for inflation;
-an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal;
-an information-inclusive approach in which many variables (not just monetary aggregates) are used in making decisions about monetary policy;
-increased transpareny of monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers;
-increased accountability of the central bank for attaining its inflation objectives

2. New Zealand was first to adoptt inflation targeting
3. Canada: inflation dropped but ue soared
4. UK: inflation fell and there was growth and reduction in ue

Advantages of inflation targeting
1. does not rely on relationship of money and inflation
2. can use all information and not just one variable
3. understood by public and highly transparent
4. increase accountability of central bank; prevent time-inconsistency trap

Disadvantages
1. delayed signaling; too much rigidity; potential for increased output fluctuations; and low economic growth
2. delayed signaling: inflation not easily controlled; unable to send immediate signals to public
3. too much rigidity: limits ability to respond to unforseen circumstances
-flexible inflation targeting in practice
4. potential for increased output fluctuations: does not require sole focus on inflation
-choose inflation targets above 0 to prevent deflation; concerned about output and ue too.