Todays Agenda

1. Adaptive and Rational Expectations

The Role of Expectations 2. Policy Conduct: Rules or Discretion?

in Macroeconomic Policy 3. The Role of Credibility and a Nominal Anchor

4. Establishing Central Bank Credibility

27-1 27-2

Adaptive and Rational Expectations

Adaptive expectations are formed from past
experiences only.

Consequently, changes in expectations will occur

Adaptive and Rational Expectations slowly over time.

27-3 27-4

1
Adaptive and Rational Expectations
Rational expectations are formed from both
past experiences AND predictions about the
future.
Consequently, changes in expectations can occur
very quickly when new information becomes
available.
27-5
Adaptive and Rational Expectations
Are households and businesses completely
rational in their expectations?
Because accurate forecasts are desirable, there are
strong incentives for households and businesses to
use all available information in making optimal
forecasts.
27-7
Adaptive and Rational Expectations
Rational expectations will be identical to
optimal forecasts, i.e., the best guess of the
future, using all available information.
However, a prediction based on rational
expectations will not always be perfectly accurate.
27-6
Adaptive and Rational Expectations
Are households and businesses completely
rational in their expectations?
However, gathering and processing the information
necessary to make optimal forecasts is both timely
and costly which may lead households and
businesses to form expectations that are less than
completely rational.
27-8
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Adaptive and Rational Expectations
There are 3 important implications of rational
expectations for macroeconomic policy
analysis.
Adaptive and Rational Expectations
1. Expectations that are rational will use ALL
available information.
This includes any information about government
policies, such as changes in monetary and fiscal
policy.

27-9 27-10

Adaptive and Rational Expectations

2. Only new information will cause rational
expectations to change.

3. If there is a change in the way a variable Policy Conduct:

moves, the way in which expectations of this
variable are formed will change as well. Rules or Discretion?

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3
Policy Conduct: Rules or Discretion? Policy Conduct: Rules or Discretion?
Should monetary policy be conducted using The Case against Discretion:
rules or discretion?
Discretionary policy can raise an issue with the
When using discretion, policy makers have no time-inconsistency problem.
commitment to future actions; instead they make
what they believe at that moment to be the right
The time-inconsistency problem recognizes that the
policy choice for the current economic situation.
best short-term result is not always consistent
with the best long-term result.
When using rules, policy makers bind themselves to
plans that specify exactly how policy will respond
to a particular economic situation.
27-13 27-14

Policy Conduct: Rules or Discretion? Policy Conduct: Rules or Discretion?

Types of Rules: The Case for Rules:

1. Non-activist rules specify that a particular A policy rule solves time-inconsistency problems
variable should behave in a specified manner. because it forces policy makers to focus on
For example, a constant-money-growth-rate rule. achieving desirable long-run outcomes.

2. Activist rules specify that monetary policy should

react to the level of output as well as inflation.
For example, the Taylor rule.

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4
Policy Conduct: Rules or Discretion?
The Case against Rules:
1. Rules may be too rigid because they cannot
foresee every contingency.
2. Rules do not easily incorporate the use of
judgment, especially of non-quantifiable data.
27-17
Policy Conduct: Rules or Discretion?
The Case for Discretion:
1. Especially in a time of crisis, being able to act
flexibly using discretion can be the key to a
successful monetary policy.
2. Monetary policy is as much an art as it is a
science; judgment still appears to be an essential
element for effective monetary policy.
27-19
Policy Conduct: Rules or Discretion?
The Case against Rules:
3. The true model of the economy cannot be
known precisely so a policy rule based on a
particular model will be wrong if the economic
model from which the rule was derived is wrong.
4. Even if the true economic model was known,
structural changes in the economy would lead to
changes in the sensitivities of the model.
27-18
Policy Conduct: Rules or Discretion?
The Case for Discretion:
3. Discretion allows policy makers to change policy
settings when an economy undergoes structural
changes.
27-20
5
Policy Conduct: Rules or Discretion?
Constrained Discretion
Constrained discretion allows monetary policy to
operate within a clearly articulated framework in
which the general objectives and tactics of the
policy makers are committed to in advance but not
their specific actions.
27-21
The Role of Credibility, a Nominal Anchor
One way to achieve constrained discretion is to
have the monetary authority credibly commit to
a nominal anchor that will allow it to achieve
price stability.
The nominal anchor could be the inflation rate, the
money supply, or even an exchange rate.
27-23
The Role of Credibility
and a Nominal Anchor
27-22
The Role of Credibility, a Nominal Anchor
Benefits of a Credible Nominal Anchor
1. A credible nominal anchor has elements of a
policy rule that helps to overcome the time-
inconsistency problem by providing an expected
constraint on discretionary policy.
2. A credible nominal anchor will help anchor
inflationary expectations, leading to smaller
fluctuations in inflation.
27-24
6
Lack of Credibility, a Positive AD Shock Credibility and a Positive AD Shock
LRAS LRAS

SRAS0(e = 0) SRAS0(e = 0)

T = 0 T = 0

AD0 AD0

YP Y YP Y
27-25 27-26

Credibility and a Positive AD Shock Lack of Credibility, a Negative AD Shock

LRAS
Monetary policy credibility has the benefit of
stabilizing inflation in the short-run when faced
with positive demand shocks.
SRAS0(e = 0)

T = 0

AD0

YP Y
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7
Credibility and a Negative AD Shock Credibility and a Negative AD Shock
LRAS
Monetary policy credibility has the benefit of
stabilizing economic output in the short-run
when faced with negative demand shocks.
SRAS0(e = 0)

T = 0

AD0

YP Y
27-29 27-30

Lack of Credibility, a Negative AS Shock Credibility and a Negative AS Shock

LRAS LRAS

SRAS0(e = 0) SRAS0(e = 0)

T = 0 T = 0

AD0 AD0

YP Y YP Y
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8
Credibility and a Negative SRAS Shock
Monetary policy credibility has the benefit of
better outcomes for both economic output and
inflation in the short-run when faced with
temporary negative aggregate supply shocks.
Establishing Central Bank
Credibility

27-33 27-34

Establishing Central Bank Credibility Establishing Central Bank Credibility

How can a central bank establish credibility?

1. Inflation targeting

2. Appoint inflation-phobic central bankers.

3. Increase central bank independence.

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Establishing Central Bank Credibility

The End

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Exam #3
When: Tuesday, Dec. 16, 11:30 2:30 p.m.

Where: Wheeler Auditorium

Coverage: Chapters 13, 16, 17, 21, and

Epilogue.

Format: 10 multiple choice questions

2 analytical questions

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