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Money and Banking
Advanced Topics
in
Monetary Policy:
Central-Bank Independence
and
Rules vs. Discretion
Mr. Vaughan
Central-Bank Independence
Factors making Fed independent:
• Governors’ terms are long and staggered.
• Chairman’s term overlaps President’s terms.
• Reserve Bank presidents are appointed by
District boards of directors.
• Funding is independent of political process—
most important factor.
How is the Fed funded?
• Most Fed income is interest on U.S. government
securities acquired through open-market operations.
• Other sources of income include:
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fees received for services provided to depository
institutions
interest on discount loans to depository institutions
• The Fed pays expenses and turns the remainder over
to the Treasury.
• About 95 percent of Fed earnings have been paid into
the Treasury since 1914.
Central-Bank Independence
Factors making Fed dependent:
• President appoints Chairman and Governors.
• “Low” governor salaries prompt high turnover.
• Congress can amend Fed legislation.
Overall, Fed is quite independent!
Should the Fed be independent?
Case for independence:
• Monetary policy will reflect the long-term
good of the country.
– Inflation rate will be lower.
• Monetary policy will not induce political
business cycles.
• Monetary policy will impose fiscal discipline
on Congress and the President.
Should the Fed be independent?
Case against independence:
• Fed structure is anti-democratic.
• Fed may pursue its own interest, not that of
the country.
• Fed performance will be dependent on
personalities (and, thus, inconsistent).
• Fed structure will hinder coordination of
monetary and fiscal policy.
Central-Bank Independence:
Cross-Country Evidence
Central bank independence produces(?) lower inflation rates.
Rules vs. Discretion
Definitions: “Rule-type policymaking involves
implementation in each period (or in each
case) of a formula designed to apply to periods
(or cases) in general, while discretionary
policymaking involves freshly made decisions
in each period or case.”
Bennett McCallum
Monetary Economics:
Theory and Policy
Case for Discretion
Discretion gives policymakers maximum
flexibility to react creatively to new policy
problems.
– Example: Fed response to 9/11
Activist vs. Non-activist Rules
•
Non-Activist Rule: No feedback from
economy
Example: M2t = 0.03 (i.e., 3% per annum growth in
all states of the world)
•
Activist Rule: includes feedback from
economy
Example: M2t = 0.03 + (unemployment ratet-1 – 0.05)
Old Case for Rules
1. Friedman: Long and variable lags make “fine
tuning” impossible.
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Recognition lag
Action lag
Impact lag
2. Buchanan: Public-choice angle
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Without rules, agency problem develops (i.e.,
central bank will pursue its interest at expense of
general public)
New Case for Rules:
Time Inconsistency
Discretionary policy has an inflationary bias.
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Policymakers play game against public.
Public understands policymakers’ incentives.
Without rules, policymaker is tempted to say one thing
and do another; public knows this and discounts
“cheap talk.”
•
End result: Higher inflation, no gain in unemployment.
To see this, we must take a detour into NAIRU!
NAIRU Framework
Non-Accelarating Inflation Rate of Unemployment
Basic Story:
• In the long run, unemployment is moored at “natural
rate.”
• Unexpectedly high money growth can temporarily
reduce unemployment rate below natural rate.
• Only repeated money surprises can keep
unemployment rate below natural rate.
Note: NAIRU is just another name for “natural rate.”
NAIRU Framework:
Natural Rate of Unemployment
Even when economy is growing at long-term
potential, some people remain unemployed.
• Frictional Unemployment: due to imperfect information
in the labor market
• Structural Unemployment: due to job/skill mismatch
NAIRU Framework:
Natural Rate of Unemployment
NAIRU Facts:
• Equilibrium level of unemployment
• Not observable
• Not constant over time
(affected by demographics, labor market frictions)
• Currently thought to be just above 5%.
NAIRU Framework:
In Pictures
Inflation Rate
Point A:
• Inflation fully expected and
reflected in nominal wage growth.
Inf1
A
Infactual = Infexpected = Inf1
• Actual unemployment rate =
Natural rate of unemployment
Un=U1
Unemployment Rate
NAIRU FrameworkIn Pictures
Inflation Rate
B
Inf2
Inf1
A
U2
Un=U1
Now, central bank unexpectedly
speeds up monetary growth.
• Economy perks up.
• Unemployment falls to U2.
• Inflation rises to inf2 .
Unemployment Rate
NAIRU Framework
Why does unemployment fall?
• Workers agreed to nominal wage contracts expecting
inflation to be inf1.
• Inflation rate ends up somewhat higher at inf2.
• Firms increase demand for labor because actual real
wage has fallen.
NAIRU framework can explain short-run non-neutrality of money!
What happens in long run?
Drop in unemployment is temporary:
• Over time, workers figure out inflation rate is higher /
real wages are lower than expected.
• Workers negotiate new nominal wage contacts based on
new inflation ratio (inf2).
• Absent additional stimulus, unemployment rate returns to
natural rate.
Money still neutral in long run!
The NAIRU Framework:
In Pictures
Inflation Rate
B
Inf2
C
Inf1
A
U2
Un=U1
Result: After adjustment of
inflation expectations,
unemployment drifts back to
the natural rate (Point C),
but with a new permanently
higher inflation rate (inf2).
Unemployment rate
NAIRU Framework
In short:
• Only repeated inflation surprises (accelerating
inflation) will keep unemployment below natural
rate.
• Misguided attempts to peg unemployment rate
below natural rate led to accelerating inflation
and rising nominal interest rates in 1970s.
NAIRU Framework:
Time-Inconsistency Angle
Can’t fool all of the people all of the time:
Central banks with discretion have incentive to renege on
commitments to price stability.
 After public has formed expectations of inflation, central bank can
increase monetary growth to reduce unemployment.
 Public will anticipate this possibility and form expectations
accordingly.
 Result: Inflation will be higher because central bank must
accommodate the expected policy (why?), but unemployment
remains at natural rate.
NAIRU Framework:
Time-Inconsistency Angle
Inflation Rate
Inf2
C
Result: In the end, inflation
Inf1
A
will be higher but
unemployment will be no lower
(point C).
Unemployment Rate
Un=U1
Policy under discretion produces results in each period
inconsistent with long-run policy goals (time-inconsistency problem).
NAIRU Framework:
Time-Inconsistency Angle
Inflation Rate
Inf2
C
Inf1
A
Un=U1
Result: Only binding rule,
can make central bank’s
commitment to price stability
credible and keep inflation at
point A.
Unemployment rate
NAIRU Framework:
Time-Inconsistency Angle
Note result (inflationary bias) does not depend on:

Imperfect knowledge

Imperfect monetary tools

Agency problems (differences in public’s and central
bank’s objective functions).
Rules vs. Discretion:
The Evidence
Rules lead to lower inflation.
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U.S. on gold standard (type of rule): bundle of goods
costing $1 in 1776 cost $1.19 in 1945.
U.S. with no rule: bundle of goods costs $1.00 in
March 1953 (Treasury-Fed Accord, discretionary
policy) would cost $8.00 today (March 2009) .
Discretion may lead to greater economic stability.
•
Many economists believe U.S. business-cycle
fluctuations have been milder since World War II.
A Closer Look at Activist Rules:
The Taylor Rule
Fed funds rate target =
inflation rate + equilibrium real fed funds rate
+ ½ (inflation gap) + ½ (output gap)
where:
• Equilibrium real fed funds rate = neutral rate
• Inflation rate = current observed rate
• Inflation target = set by policy makers
• Inflation gap = current inflation rate – inflation target
• Output gap = percentage deviation of current real
GDP from estimate of potential GDP
A Closer Look at Activist Rules:
The Taylor Rule
Example:
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Equilibrium real fed funds rate = 2%
Inflation target = 2%
Current inflation rate = 3%
Inflation gap = current inflation (3%) – inflation target (2%)
Output gap = Current real GDP is 1% above potential.
Fed funds rate target =
(3%) + (2%) + ½ (1%) + ½ (1%) = 6%
Time-Inconsistency Problem
Other Solutions
Besides rules…
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Reputation building
Incentive-compatible contracts for central
bankers
“Conservative” central bankers
Inflation Targeting:
A Middle Ground?
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Not really a rule; not really discretion either.
Basic features:
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Central bank announces official inflation target
Central bank explicitly acknowledges that low and stable
inflation is overriding goal of monetary policy.
Central bank becomes more transparent and more
communicative with public.
Central bank held accountable for attaining inflation
targets.
Basic Flaw: Can you really hold central bank
accountable for an inflation target?
How does the Fed set policy?
Taylor Rule and Fed Funds Rate
1960-2003
Taylor rule describes policy under Greenspan fairly well.
Questions
over:
Advanced Topics
in
Monetary Policy:
Central-Bank Independence
and
Rules vs. Discretion?
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