Chapter 17: Monetary Policy Targets and Goals

Chapter Objectives• Explain why the Fed was generally so ineffective before the late 1980s.• Explain why macroeconomic volatility declined from the late 1980s until

2008.• List the trade-offs that central banks face and describe how they confront

them.• Define monetary targeting and explain why it succeeded in some countries

and failed in others.• Define inflation targeting and explain its importance.• Provide and use the Taylor Rule and explain its importance.

2. Central Bank Goal Trade-offs

Maximize price stability

Minimize unemployment

Primary objective of Central banks

2. Central Bank Goal Tradeoffs

UnemploymentFrictional is a little unemployment; allows the labor

market to function smoothly Structural when workers’ skills do not match job

requirements; inevitable in a dynamic economy

As structural unemployment increased in the United States, education improved somewhat

Fed shoots for natural rate of unemployment—could be 5 percent, give or take

3. Central Bank Targets

GoalMaximize price stability

Minimize unemployment• Hold the line (no ∆)• Tighten (increase i, decrease or slow the growth of MS) • Ease (lower i, increase MS)

Tools• Open market operations• Discount rate• Reserve requirement

3. Central Bank Targets

Target: Aggregate MS (M1 or M2)

Problems• Time inconsistency• Time lags between policy implementation and real-

world effects• Difficulty predicting the importance of specific

aggregates as a determinant of interest rates and the price level

• Disjoint between tools and targets

3. Central Bank Targets

Target: Inflation

• Frees central banks to do whatever it takes to keep prices in check

• Forces central banks to use all available information and not just monetary statistics

• Makes central banks more accountable – success or failure is easily monitored

4. The Taylor Rule

“What is a monetary policy rule? At its most basic level, it is a contingency plan that lays out how monetary policy decisions are, or should be, made. Let me start with the example of the Taylor rule... Originally the rule was meant to be normative: a recommendation of what the Fed should do. It was derived from monetary theory, or more precisely from optimization exercises using new dynamic stochastic monetary models with rational expectations and price rigidities.”

-- John Taylor, the Adam Smith Lecture, Annual Meeting of the National Association of Business Economics September 10, 2007

4. The Taylor Rule

The Taylor Rulefft = π + ff*r + ½(π gap) + ½(Y gap)

• fft = federal funds target• π = inflation • ff*r = the real equilibrium fed funds rate• π gap = inflation gap (π – π target)• Y gap = output gap (actual output [e.g. GDP] - output

potential)

4. The Taylor Rule

The Taylor Rulefft = π + ff*r + ½(π gap) + ½(Y gap)

If π gap > 0, then π > π target, then fft > ff*r

Or, if inflation is greater than target inflation, the target fed funds rate should be raised.

If π gap < 0, then π < π target, then fft < ff*r

Or, if inflation is less than target inflation, the target Fed Funds rate should be lowered.

4. The Taylor Rule

The Taylor Rulefft = π + ff*r + ½(π gap) + ½(Y gap)

Is counter-cyclical:If inflation or output indicates overheating, the target

fed funds rate should be raised to slow growth.Or

If deflation or excess capacity indicates sluggishness, the target fed funds rate should be lowered to

stimulate growth.

4. The Taylor Rule

The Taylor Rulefft = π + ff*r + ½(π gap) + ½(Y gap)

is counter-cyclicaland accounts for two important Federal Reserve goals:

price stability and employment/output.Since 1960, when the fft and the Taylor Rule were closely matched, the economy has had low inflation

and strong growth.