Download Characterizing Monetary Policy In the old days, monetary

The Next Topic: Characterizing Monetary Policy
In the old days, monetary policy was defined in terms of a
path for the money supply. In 1993, John Taylor
suggested instead a simple feedback rule for nominal
interest rates:
rt¿ = (rrtn + ¼¤ ) + Á¼ (¼t ¡ ¼¤ ) + Áy (yt ¡ y¹t )
rt¿ = the Fed Funds Rate (target rate)
rrtn = the real interest rate consistent with full employment
¼¤ = the target in°ation rate = 0 in G&G
y¹t = full employment output
(Á¼ ; Áy ) = constants
Monetary Policy
Using G&G notation
rt¿ = rrtn + Á¼ ¼t + Áy y~t
Hence, if inflation is zero and the economy is at full employment,
then the Fed Funds rate is set equal to the full employment
real interest rate.
But if the economy is “overheating”: ¼t > 0; y~t > 0 then raise
the target rate. Critically the coefficient on inflation needs to
be greater than 1. To see this subtract inflation from both
sides
Monetary Policy Rule
The Taylor rule becomes
rt¿ ¡ ¼t = rrtn + Á¼ ¼t ¡ ¼t + Áy y~t
| {z }
rrt¿
Or, rearranging terms
rrt¿ = rrtn + (Á¼ ¡ 1) ¼t + Áy y~t
Recall from the IS curve, that to contract AD, the long term
interest rate must increase. If Á¼ < 1 , then an increase in
inflation will cause a fall in real interest rates…AD will
increase rather than decrease.
An historical analysis of monetary policy using the
Taylor rule.
rt¿ = rrtn + Á¼ ¼t + Áy y~t
Recently, the parameters of the Taylor rule have been estimated for
different sample periods. These estimates are presented below:
60:1 - 79:4
87:1 - 97:3
Variable
Estimate
Estimate
Á¼
Áy
0.813
1.533
0.252
0.765
Note critically that the coefficient on inflation was less than 1 during
the 60’s and 70’s. This means that increases in inflation lower the
real interest rate which causes demand to increase -- this results in
even higher inflation. Hence, inflation becomes unstable.
Graphically we can show the difference by assuming output is always equal to
full employment and the long run real interest rate = 2%. Then the Taylor
rule in the sample periods becomes:
1960 ¡ 1979 : Rt = 2:045 + 0:813¼t
1987 ¡ 1997 : Rt = 1:174 + 1:533¼t
In the early period, inflation is unstable – departures from equilibrium grow.
Comparison of actual and predicted Fed Funds
Rate using the Taylor rule
The following graphs examine the path of the Fed Funds rate predicted by two Rules.
Rule 1: (Á¼ = 1:5; Áy = 0:5)
Rule 2: (Á¼ = 1:5; Áy = 1:0)
For the late 1970’s and early 1980’s we have:
Greenspan seemed to do a good job through the mid to late
90’s
The Taylor rule predictions can be monitored via the St.
Louis Fed’s web site Monetary Trends.
(http://research.stlouisfed.org/publications/mt/)
Here is what the latest version shows:
Current conditions
Recently John Taylor claims that the low Fed Funds rate
from 2003-2006 was important for the behavior of house
prices. From an Economist article
At this year’s annual central bankers’ symposium in Jackson Hole,
Wyoming, Mr Taylor ran his own rule over the Fed (see chart 6).
Had the central bank followed it, rates in 2002 would have been
going up not down. By the time rates started to rise, the gap
between the actual rate and that indicated by the Taylor rule was
three percentage points. The gap was finally closed only last
year—long after fears of deflation had been banished. The Fed
has departed from the rule at other times in the past couple of
decades, said Mr Taylor, notably in the autumn of 1998, “but this
was the biggest deviation, comparable to the turbulent 1970s.”
Did the Fed cause the Housing Bubble?
Had the Fed acted differently, would the boom and bust have been less marked? At
Jackson Hole Mr Taylor said it would. He reckons that the Fed’s policy explains housing
starts fairly well until mid-2004, when interest rates started to rise; by then, the boom had
its own momentum. Under the Taylor rule, starts would have peaked sooner—around two
years earlier than happened in real life—and at a much lower level.
Last Topic: Aggregate Supply
z
We will next discuss the AS curve and then
analyze how monetary policy affects the
economy.
z
Critical: The credibility of the Fed!