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Published on April 8, 2008

Author: Irvette


Chapter 19:  Chapter 19 Optimizing Monetary Policy in the Future Requirements of Monetary Policy:  Requirements of Monetary Policy Any central banker will say that the principal role of monetary policy is to keep inflation low and stable. That is true, but only if two other key conditions are also observed. Insure adequate liquidity for the needs of commerce and industry Reduce and shorten any business cycle downturns. Monetary Policy in Never-Never Land:  Monetary Policy in Never-Never Land If there were no exogenous shocks, monetary policy would be very simple. Once credibility had been established, the central bank would simply keep the short-term interest rate at its equilibrium value, generally defined as the growth rate in real GDP plus some modest level of inflation. The Optimal Rate of Inflation:  The Optimal Rate of Inflation It isn’t zero. That would imply as many prices are declining as are rising. A decline in asset prices leads to a drop in wealth and an increase in bankruptcies. Deflation is positive only when it is driven by improving technology, not deficient demand. Also, declining wage rates leads to labor unrest. A Slightly Positive Rate:  A Slightly Positive Rate Then what should it be? Paul Volcker said inflation should be low enough not to influence economic decisions, and Alan Greenspan has endorsed that view. Given the difficulties in measuring inflation, and given the negative features of deflation, most economists would put the optimal measured rate of inflation in the 1% to 2% range. Disturbances from Equilibrium:  Disturbances from Equilibrium If the economy starts to overheat, the short-term interest rate should be raised. If the economy heads into a slump, the short-term rate should be lowered. These rules are much easier to enforce when the value of the currency is stable and the budget is balanced over the cycle. But suppose they are not. Then how should the central bank authorities act? Reaction to Changes in the Currency:  Reaction to Changes in the Currency The answers are not always the same. For example, suppose the currency rises above its equilibrium value; the normal response would be for the central bank to ease. But suppose the currency rose because foreign investors were attracted by the strong economy. In that case, reducing interest rates would probably lead to overheating and bubble in stock prices or land values. Reactions to Recessions:  Reactions to Recessions Suppose the economy goes into recession, and in addition to the automatic stabilizers, the government institutes a set of policies designed to stimulate the economy that would lead to a full-employment budget deficit. Should the central bank tighten to offset that stimulus? That would not only be counterproductive economically, but runs the very real risk of having the authority of the central bank curtailed when it really is necessary. Reaction to Energy Shocks:  Reaction to Energy Shocks Now consider an energy shock, which boosts inflation and reduces real growth at the same time. The central bank now faces conflicting signals. Tightening would worsen the recession now, but easing would send a signal that caution has been thrown to the winds, probably leading to a more severe recession later. Once again, there are no easy answers. No Simple Rules:  No Simple Rules When you get right down to it, there are no simple answers. One size does not fit all. Monetary policy cannot be put on automatic pilot. It must be sculpted to fit the existing circumstances. Also, most people learn by their past mistakes. Hence the reaction of the economy to a given monetary policy one time may be quite different than it was the previous time. What Rules Should be Followed?:  What Rules Should be Followed? Given these inherent contradictions, what are the best set of monetary policies that can be followed, given that in the real world we can expect to have currency fluctuations, budget deficits, changing expectations, and recurring exogenous shocks from time to time? Rules to Follow, Slide 2:  Rules to Follow, Slide 2 Fed must establish credibility Announce in advance what it plans to do. Secrecy actually doesn’t work so well Must serve as the last option to maintain liquidity and prevent a financial crash, but cannot be seen as an agency that is all too willing to bail out high rollers who took unwarranted risks and lost. Cases where inflation and recession occur at the same time are the hardest of all for the Fed. Nonetheless, the economy will be better served if inflation is fought first and then recession is tended to later. Rules to Follow, Slide 3:  Rules to Follow, Slide 3 We have the evidence from the 1970s. The first time around, Burns fought recession instead of inflation. The result was another round of double-digit inflation and two more recessions in the next six years. The second time, Volcker first fought inflation. The recession lasted six months longer than usual, but was followed by two decades of unprecedented prosperity. Rules to Follow, Slide 4:  Rules to Follow, Slide 4 In general, it is better to be ahead of the curve than behind it. Given that the Fed is not perfect, and the economic statistics are sometimes erroneous, it is still far better to take an initial small step before it is too late; if it proves unnecessary, it can always be reversed before a major economic disruption occurs. Moral Hazard:  Moral Hazard Suppose you had a $1 billion to invest. There was a 20% chance you will make $5 billion and a 80% chance you will lose it all. Since the expected value is $1 billion, some will take this risk and some won’t. But now suppose the central bank says it can’t afford to have you lose $1 billion, so it will make up any losses. Of course, under that case, everyone would take the risk Actual real world situations are never that black and white. But even if there is a slight chance that the government will bail them out, far too many investors will take that extra risk. As a result, the chances for financial market bubbles are substantially increased. What’s Wrong With Inflation?:  What’s Wrong With Inflation? Emphasis has been placed on the role of monetary policy in keeping inflation low and stable. But what are the drawbacks to higher inflation? It used to be said that inflation redistributed income away from people on fixed income. However, most industrialized countries now index these payments, so that no longer applies. What’s Wrong With Inflation, Slide 2:  What’s Wrong With Inflation, Slide 2 The major impact of high inflation is not on the demand side, but on the supply side. It reduces productivity growth and the standard of living. Investments will be made that are likely to increase in value, rather than boost productivity. Speculation will become rampant, with fewer people willing to work at ordinary jobs. Graft and corruption will increase as the pricing system breaks down. Summary: Rules for Optimal Flexible Monetary Policy:  Summary: Rules for Optimal Flexible Monetary Policy Fed should tighten whenever inflation starts to rise unless that would precipitate a financial crisis. If the economy is growing, unemployment is still above the full-N level, and inflation is low and stable, policy should remain unchanged. Once full N is reached, the Fed should announce in advance its contingency plans to tighten if inflationary pressures start to build. Summary Rules, Slide 2:  Summary Rules, Slide 2 If a supply-side shock boosts inflation, the Fed is better off fighting inflation first and recession later. If the budget would still be in deficit at full N, the Fed should keep policy stable until that point is reached, and should then tighten. If the dollar rises above equilibrium, the Treasury and Fed should intervene in forex markets but not necessarily tighten monetary policy. It should defend the dollar against declining below equilibrium. Financial crises take precedence over all other policies in the short run.

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