The Conduct of Monetary Policy Strategy and Tactics

Chapter 19
The Conduct of
Monetary Policy:
Strategy and
Tactics
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

How does money affect
economic activities?
• The classic Keynes theory
M -> ir -> I -> Y
16-2
Linkages Between Central Bank Tools, Policy
Instruments, Intermediate Targets, and Goals
of Monetary Policy
16-3
Tactics: Choosing the Policy
Instrument
• Tools
– Open market operation
– Reserve requirements
– Discount rate
• Policy instrument (operating instrument)
– Reserve aggregates
– Interest rates
– May be linked to an intermediate target
• Interest-rate and aggregate targets are
incompatible (must chose one or the other).
16-4
FIGURE 3 Result of Targeting on
Nonborrowed Reserves
16-5
FIGURE 4 Result of Targeting on
the Federal Funds Rate
16-6
Criteria for Choosing the
Policy Instrument
• Observability and Measurability
• Controllability
• Predictable effect on Goals
16-7
The Taylor Rule
Federal funds rate target =

inflation rate  equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
• An inflation gap: actual inflation – target inflation

rate
• An output gap: actual GDP growth rate – target
GDP growth rate
16-8
FIGURE 5 The Taylor Rule for the
Federal Funds Rate, 1970–2008
Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.
16-9
Strategy
• Due to the time-inconsistency problem
• Choosing an anchor for monetary policy
– Monetary targeting
– Inflation targeting
– Exchange rate targeting
– Implicit anchor
– Interest rate targeting
16-10
Inflation Targeting I
• Public announcement of medium-term numerical

target for inflation
• Institutional commitment to price stability as the
primary, long-run goal of monetary policy and a
commitment to achieve the inflation goal
• Information-inclusive approach in which many
variables are used in making decisions
• Increased transparency of the strategy
• Increased accountability of the central bank
16-11
Inflation Targeting II
• New Zealand (effective in 1990)

– Inflation was brought down and remained within the
target most of the time.
– Growth has generally been high and unemployment has
come down significantly
• Canada (1991)
– Inflation decreased since then, some costs in term of
unemployment
• United Kingdom (1992)
– Inflation has been close to its target.
– Growth has been strong and unemployment has been
decreasing.
16-12
Inflation Targeting III
• Advantages
– Does not rely on one variable to achieve target
– Easily understood
– Reduces potential of falling in time-
inconsistency trap
– Stresses transparency and accountability
• Disadvantages
– Delayed signaling
– Too much rigidity
– Potential for increased output fluctuations
– Low economic growth during disinflation
16-13
FIGURE 1 Inflation Rates and Inflation Targets
for New Zealand, Canada, and the United
Kingdom, 1980–2008
Source: Ben S. Bernanke,

Thomas Laubach, Frederic S.
Mishkin, and Adam S. Poson,
Inflation Targeting: Lessons
from the International
Experience (Princeton: Princeton
University Press, 1999), updates
from the same sources, and
www.rbnz.govt
.nz/statistics/econind/a3/ha3.xls
.
16-14
Interest rate targeting
• Since 1994, the Fed announces its federal
fund rate
• Preemptive strikes against inflation,
economic downturns and financial
disruptions
16-15
Monetary Policy with an
Implicit Nominal Anchor
• There is no explicit nominal anchor in the
form of an overriding concern for the Fed.
• Forward looking behavior and periodic
“preemptive strikes”
• The goal is to prevent inflation from getting
started.
• “Just do it” approach
16-16
Monetary Policy with an
Implicit Nominal Anchor II
• Advantages
– Uses many sources of information
– Avoids time-inconsistency problem
– Demonstrated success
• Disadvantages
– Lack of transparency and accountability
– Strong dependence on the preferences, skills, and
trustworthiness of individuals in charge
– Inconsistent with democratic principles
16-17
Chapter summary
• What are imtermidiate targets and how to
choose one?
• What are strategies available to central to
conduct monetary policy? What are the
characteristics of each strategy? What are
the advantage and disadvantage of each
strategy?
16-18

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Chapter 19

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

M -> ir -> I -> Y

Federal funds rate target =

• An inflation gap: actual inflation – target inflation

Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.

• Public announcement of medium-term numerical

• New Zealand (effective in 1990)

Source: Ben S. Bernanke,

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