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Monetary Policy
The Optimal Inflation Rate?
Inflation Rates in the OECD, 1981-2000
1981
OECD average (%)
Number of countries
with inflation below 5%
 Inflation
10.5
2
1985
1990
6.6
6.2
10
15
1995
2000
5.2
2.5
21
24
has steadily gone down in rich
countries since the early 1980s.
 Should inflation be reduced even further?
The Costs of Inflation
 Shoe-leather
costs are the costs of
making more trips to the bank.
 Tax distortions occur when tax rates do
not increase automatically (bracket creep).
 Money illusion: people make systematic
mistakes in assessing nominal versus real
changes.
 Inflation variability: financial assets such
as bonds, which promise fixed nominal
payments in the future, become riskier.
The Benefits of Inflation

Seignorage, or the revenues from money
creation, allow the government to borrow less
from the public, or to lower taxes.


Seignorage income for the U.S.
The presence of inflation allows for downward
real-wage adjustments more easily than when
there is no inflation.
The Optimal Inflation Rate:
The Current Debate

Those who aim for small but positive inflation
argue that some of the costs of positive inflation
can be avoided, and the benefits are worth
keeping.
 Those who aim for zero inflation argue that this
amounts to price stability, which simplifies
decisions and eliminates money illusion.
 Today, most central banks appear to be aiming
for a low but positive inflation, between 2 and
4%.
The importance of ideology
(Republicans and Democrats)
Politics continued…
Official Goals of the Fed
 Promote
Maximum Employment
 Maintain Stable Prices
 Achieve Moderate Long-Term Interest
Rates
The Design of Monetary Policy:
Money Growth
 The
choice of an optimal inflation rate
determines the rate of nominal money
growth.
  gm  g y
 The central bank may want to announce a
target for nominal money growth, and make it
clear how it would deviate from it to address
short-run fluctuations.
 Until recently, this is how monetary policy has
been conducted in most countries.
Money Growth and Inflation Revisited
 The
design of monetary policy around
nominal money growth is based on the
assumption that a close relation between
inflation and nominal money growth exists
in the medium run.
 The problem is that this relation is not very
tight.
M1 Growth and Inflation
M1 Growth and
Inflation:
10-year averages
1970-2000
The Design of Monetary Policy:
Inflation Targeting
 Many
central banks have defined as their
primary, and sometimes exclusive goal,
the achievement of a low inflation rate.
 Inflation targeting would lead the central
bank to act in such a way as to eliminate
all deviations of output from the natural
level of output.
The Design of Monetary Policy:
Interest Rate Targeting

Taylor’s Rule: According to Taylor, since it is the
interest rate that directly affects spending, the
central bank should choose an interest rate
rather than a rate of nominal money growth.
it = i* + a( πt - πe ) - b( ut - un )
 If π t = π t- 1 and ut  un , then the central
bank should set it equal to its target value, i*.
Taylor’s Rule
it = i* + a( πt - πe ) - b( ut - un )

The higher the value of a, the more the central
bank will increase the interest rate in response
to inflation.
 The higher the value of b, the more the central
bank will be willing to deviate from target
inflation to keep unemployment close to the
natural rate.
 In sum, these coefficients reflect how much the
central bank cares about unemployment versus
inflation.
Taylor’s Rule
it = i* + a( πt - πe ) - b( ut - un )
 Taylor’s
rule provides a way of thinking
about monetary policy: once the central
bank has chosen a target rate of inflation,
it should try to achieve it by adjusting the
nominal interest rate.
 This rule actually describes quite well the
behavior of many central banks in the past
15-20 years.
The Fed and the Interest Rate
The Organization of the Fed
 The
Federal Reserve System is composed
of three parts:
 A set of 12 Federal Reserve Districts
 The Board of Governors (7 members)
 The Federal Open Market Committee
(FOMC).
The Fed’s Districts
The Instruments of Monetary
Policy
 The
equilibrium interest rate is the interest
rate at which the supply and the demand
for central bank money are equal.
 The money supply, refers to the monetary
base.
 The demand for money is the sum of the
demand for currency and the demand for
reserves by banks.
1. Reserve Requirements

Reserve requirements are the minimum
amount of reserves that banks must hold in
proportion to checkable deposits.
 By changing reserve requirements, the Fed
effectively changes the demand for central bank
money.
 This instrument of monetary policy is not widely
used because banks may take drastic actions to
increase their reserves, such as recalling some
of the loans.
2. Lending to Banks
 The
Fed can also lend to banks, thereby
affecting the supply of central bank
money.
 The set of conditions under which the Fed
lends to banks is called discount policy.
The Fed lends at a rate called the
discount rate, through the discount
window.
 Today, changes in the discount rate are
used mostly as a signal to financial
markets.
3. Open-Market Operations
 Open-market
operations, the purchase
and sale of government bonds in the
open market, is the main instrument of
U.S. monetary policy. It is convenient
and flexible.
 When the Fed buys bonds, it pays for
them by creating money, thereby
increasing the money supply, H. When it
sells bonds, it decreases H.
The Fed can pursue expansionary
monetary policy by…
…open market purchases of bonds.
or
…reducing the discount rate.
or
…reducing banks’ reserve requirement.
All of these will result, in the short run, in the
LM curve shifting to the right.
The Practice of Policy

The most important monetary policy decisions
are made at meetings of the FOMC.
 Fed staff prepares forecasts and simulations of
the effects of different monetary policies on the
economy, and identifies the major sources of
uncertainty.
 The conduct of open-market operations between
FOMC meetings is left to the Open Market Desk.
The Practice of Policy
 Does
the Fed have a money growth target,
an inflation target, or follow an interest rate
rule?
 The answer: we don’t know.
The Fed and the Output Gap