Prepared By: Fernando Quijano and Yvonn Quijano: - Macroeconomics, 5/e - Olivier Blanchard

Monetary Policy:
A Summing Up
CHAPTER 25
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
25-1 The Optimal Inflation Rate
Table 25-1 Inflation Rates in OECD Countries since 1981
Year 1981 1985 1990 1995 2000 2006

OECD average* 10.5% 6.6% 6.2% 5.2% 2.8% 2.2%
Number of countries with

inflation below 5%† 2 10 15 21 24 25
* Average of GDP deflator inflation rates, using relative GDPs measured at PPP prices as weights.
Chapter 25: Monetary Policy: A Summing Up
Inflation has steadily gone down in rich countries

since the early 1980s.
The attempt to reduce it even further depends on

the costs and benefits of inflation.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 34
Monetary Policy: What You Have
Learned and Where
A quick review of Chapters 4 through 24 and

an overview of the information presented in
Chapter 25.
The Costs of Inflation
We’ve seen how very high inflation can disrupt economic activity.
The debate in OECD countries today, however, centers on the
advantages of, say, 0% versus 3% inflation a year. Within that
range, economists identify four main costs of inflation:
(1) shoe-leather costs,

(1) tax distortions,
(1) money illusion, and
(1) inflation variability.
Shoe-leather Costs
Shoe-leather costs are the costs of making more trips to the

bank in the presence of inflation. They reflect an increase in the
opportunity cost of holding money ( HIGHER INFLATION MEANS
HIGHER NOMINAL INTEREST RATES).
Tax Distortions
In the United States, there are many taxes that do not automatically
adjust for inflation. For example, capital gains taxes are calculated based
on the absolute increase in value of an asset, not on the inflation-adjusted
value increase. Therefore, the effective tax rate on capital gains when
inflation is present may be much higher than the stated nominal rate.
Similarly, inflation increases the effective tax rate paid on interest income.
(eg>>>)
Tax Distortions - Example
Suppose that you bought some asset for $100 in period 1 and sold it for
$110 in period 2. You made a profit of $10 (10%). You have a
nominal gain of $10, but whether you made a gain in real terms or
not depends on inflation. If there is no inflation between periods 1
and 2, then your real gain is 10%. You can buy 10% more goods
and services with $110 in period 2 than you could with $100 in
period 1. Now suppose that inflation between periods 1 and 2 was
10%. In this case, you can buy as many goods and services with
$110 in period 2 as you could with $100 in period 1—you made no
real gains. Yet, regardless of whether you made any real gains or
not, you may still have to pay taxes on the nominal gain.
Money Illusion
Money illusion is the cost of inflation associated with the
notion that people make systematic mistakes in assessing
nominal versus real changes, leading people to make
incorrect decisions.
Inflation Variability
Inflation variability means that financial assets such as

bonds, which promise fixed nominal payments in the
future, become riskier. Why? Because the real value of
the bond is unknown when inflation rises, since bonds
pay fixed income, higher inflation eats up purchasing
power. Concept of hedging against inflation
Money Illusion
There is a lot of anecdotal evidence that many people

fail to adjust properly for inflation in their financial
computations.
Recently, economists and psychologists have started
looking at money illusion more closely. In a recent

study, two psychologists, Eldar Shafir from Princeton
and Amos Tversky from Stanford, and one economist,
Peter Diamond from MIT, designed a survey aimed at
finding how prevalent money illusion is and what
causes it.
After conducting the study, it is suggested that money
illusion is very prevalent and that people have a hard
time adjusting for inflation.
The Benefits of Inflation
Inflation is actually not all bad. One can identify three benefits
of inflation:
(1) seignorage,
(2) the option of negative real interest rates for

macroeconomic policy, and
(3) the use of the interaction between money illusion and

inflation in facilitating real wage adjustments.
Seignorage
Seignorage, or the revenues from money creation, allow
the government to borrow less from the public, or to
lower taxes.
An economy with a higher average inflation rate has

more scope to use monetary policy to fight a recession.
The Option of Negative Real Interest Rates
In short, an economy with a higher average inflation

rate has more scope to use monetary policy to fight a
recession. An economy with a low average inflation
rate may find itself unable to use monetary policy to
return output to a natural level of output.
Money Illusion Revisited
Paradoxically, the presence of money illusion provides at

least one argument for having a positive inflation rate.
The presence of inflation allows for downward real-wage

adjustments more easily than when there is no inflation.

Remember Nominal wage is more difficult to adjust
downward
The Optimal Inflation Rate: The Current Debate
Those who aim for small but positive inflation argue that
some of the costs of positive inflation can be avoided, and
the benefits are worth keeping.
Those who aim for zero inflation argue that this amounts to
price stability, which simplifies decisions and eliminates

money illusion.
Today, most central banks appear to be aiming for a low but

positive inflation, between 2 and 3%.
25-2 The Design of Monetary Policy
Most central banks have adopted an inflation rate

target rather than a nominal money growth rate
target. And, they think about short-run monetary
policy in terms of movements in the nominal interest
rate rather than in terms of movements in the rate of
nominal money growth.
Money Growth Targets and Target Ranges
Until the 1990s, monetary policy, in the US and other
OECD countries, was typically conducted as follows:
 The central bank chose a target rate for nominal

money growth corresponding to the inflation rate
it wanted to achieve in the medium run.
 In the short run, the central bank allowed for

deviations of nominal money growth from the target.
 To communicate to the public both what it wanted to

achieve in the medium run and what it intended to do
in the short run, the central bank announced a range
for the rate of nominal money growth.
Money Growth and Inflation Revisited
Figure 25 – 1
There is no tight relation between M1 growth and inflation—not
M1 Growth and Inflation: even in the medium run.
10-Year Averages since
1970
Money Growth and Inflation Revisited
The relation between M1 growth and inflation is not
tighter because of shifts in the demand for money.
When people reduce their bank account balances and

move to money market funds, there is a negative shift
in the demand for money.
Frequent and large shifts in money demand created

serious problems for central banks.
Inflation Targeting
In many countries, central banks have defined as their
primary goal the achievement of a low inflation rate, both in
the short run and in the medium run. This is known as
inflation targeting.
 Trying to achieve a given inflation target in the medium

run would seem a clear improvement over trying to

achieve a nominal money growth target.
 Trying to achieve a given inflation target in the short run

would appear to be much more controversial.
The Unsuccessful Search for the Right
Monetary Aggregate
Measures that include not only money but other liquid

assets are called monetary aggregates, under the name
of M2, M3, and so on.
In the United States, M2 is also called broad money.

The central bank could choose M2 growth as target,

however the relation between M2 growth and inflation is
not very tight either, and the central bank does not control
M2. Many financial assets are very liquid (financial assets
that can be exchanged for money at little cost), which
makes them attractive as substitutes for money. However,
these assets are not included in M1.
The Unsuccessful Search for the Right
Monetary Aggregate
Figure 1 M2 Growth and Inflation: 10-Year Averages since 1970
Inflation Targeting
The result that we have just derived – that inflation
targeting eliminates deviations of output from its
natural level – is too strong, however, for two reasons:
 The central bank cannot always achieve the rate

of inflation it wants in the short run.
 Like all other macroeconomic relations, the

Phillips curve relation does not hold exactly.
Interest Rate Rules
According to the Taylor rule, since it is the interest

rate that directly affects spending, the central bank
should choose an interest rate rather than a rate of
nominal money growth.
it  i *  a( t   *) b(ut  un )

Taylor’s rule provides a way of thinking about

monetary policy: Once the central bank has chosen a
target rate of inflation, it should try to achieve it by
adjusting the nominal interest rate.
Interest Rate Rules
it  i *  a( t   e )  b(ut  un )
 If  t   *, and ut  un , then the central bank should set it

equal to its target value, i*.
 If inflation is higher than the target ( t   *) , the central

bank should increase the nominal interest rate it above i*.
 If unemployment is higher than the natural rate of

unemployment (u>un), the central bank should decrease
the nominal interest rate.
Interest Rate Rules
Since it was first introduced, the Taylor rule has generated a lot of
interest, both from researchers and from central banks:
 Researchers looking at the behavior of both the Fed in the

US and the Bundesbank in Germany have found the rule
describes their behavior over the last 15-20 years.
 Other researchers have explored whether it is possible to

improve on this simple rule.
 Yet other researchers have discussed whether central banks

should adopt an explicit interest rate rule and follow it closely.
 In general, most central banks have now shifted to thinking in

terms of an interest rate rule.
25-3 The Fed in Action
The Mandate of the Fed
The mandate of the Federal Reserve System was
most recently defined in the Humphrey-Hawkins
Act, passed by Congress in 1978.
For more information on how the Fed is organized, go

to the Fed’s Web site:
www.federalreserve.gov/
The Organization of the Fed
The Federal Reserve System is composed of three parts:
 A set of 12 Federal Reserve Districts
 The Board of Governors

 The Federal Open Market Committee (FOMC)

and the Open Market Desk.
The Instruments of Monetary Policy
H  [c   (1  c)]$YL(i )
The equilibrium interest rate is the interest rate at which the
supply (left side) and the demand (right side) for central
bank money are equal.
The money supply, H, refers to the monetary base. The

demand for money is the sum of the demand for currency
and the demand for reserves by banks (refer to chapter 4
for more detail).
Reserve Requirements
Reserve requirements are the minimum amount of
reserves that banks must hold in proportion to checkable
deposits.
By changing reserve requirements, the Fed effectively

changes the demand for central bank money.
This instrument of monetary policy is not widely used

because banks may take drastic actions to increase their
reserves, such as recalling some of the loans.
Lending to Banks
The Fed can also lend to banks, thereby affecting the

supply of central bank money.
The set of conditions under which the Fed lends to banks

is called discount policy. The Fed lends at a rate called

the discount rate, through the discount window.
Today, changes in the discount rate are used mostly as a

signal to financial markets.
Open Market Operations
Open-market operations, the purchase and sale of

government bonds in the open market, is the main
instrument of U.S. monetary policy. It is convenient
and flexible.
When the Fed buys bonds, it pays for them by

creating money, thereby increasing the money
supply, H. When it sells bonds, it decreases H.
The Implementation of Policy
The most important monetary policy decisions are made
at meetings of the FOMC.
Fed staff prepares forecasts and simulations of the

effects of different monetary policies on the economy,
and identifies the major sources of uncertainty.
The conduct of open-market operations between FOMC

meetings is left to the Open Market Desk.
Does the Fed have an inflation target, or follow an interest

rate rule?
 The answer is: we don’t know. Alan Greenspan, the

chairman of the Fed until 2006, never specifically
stated an inflation target, nor has his successor, Ben

Bernanke.
 The evidence strongly shows that the Fed has in fact

an implicit inflation target of about 2-3%. It is also
clear that the Fed adjusts the federal funds rate in
response both to the inflation rate and to deviations of
unemployment from the natural rate.
Does it matter that the Fed has neither an explicit
inflation target nor an explicit interest rate rule?
 Many economists say: Do not argue with success.

The record of monetary policy under both Alan
Greenspan and Ben Bernanke has been

outstanding.
 Other economists are more skeptical. They argue

that it is unwise to have monetary policy depend so
much on one individual, that the next Chairman of
the Fed may not be able to achieve the same mix of
credibility and flexibility.
Figure 25 – 2 In 1990–1991, and again in 2001, the Fed dramatically decreased

The Federal Funds Rate the federal funds rate to reduce the depth and length of the
since 1987 recession.
Key Terms
 shoe-leather costs  Federal Reserve Districts

 money illusion  Board of Governors
 inflation targeting  Federal Open Market
Committee (FOMC)
 liquid asset
 Open Market Desk
 monetary aggregates,
 reserve requirements
 broad money (M2)
 discount policy
 Taylor rule  discount rate
 Humphrey-Hawkins Act  discount window

Prepared By: Fernando Quijano and Yvonn Quijano: - Macroeconomics, 5/e - Olivier Blanchard

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Prepared By: Fernando Quijano and Yvonn Quijano: - Macroeconomics, 5/e - Olivier Blanchard

Загружено:

Авторское право:

Доступные форматы

Monetary Policy:

Table 25-1 Inflation Rates in OECD Countries since 1981

Year 1981 1985 1990 1995 2000 2006

Number of countries with

Inflation has steadily gone down in rich countries

The attempt to reduce it even further depends on

A quick review of Chapters 4 through 24 and

(1) shoe-leather costs,

(1) tax distortions,

(1) money illusion, and

(1) inflation variability.

Shoe-leather costs are the costs of making more trips to the

Inflation variability means that financial assets such as

There is a lot of anecdotal evidence that many people

looking at money illusion more closely. In a recent

(2) the option of negative real interest rates for

(3) the use of the interaction between money illusion and

An economy with a higher average inflation rate has

In short, an economy with a higher average inflation

return output to a natural level of output.

Paradoxically, the presence of money illusion provides at

The presence of inflation allows for downward real-wage

adjustments more easily than when there is no inflation.

price stability, which simplifies decisions and eliminates

Today, most central banks appear to be aiming for a low but

Most central banks have adopted an inflation rate

 The central bank chose a target rate for nominal

it wanted to achieve in the medium run.

 In the short run, the central bank allowed for

 To communicate to the public both what it wanted to

When people reduce their bank account balances and

in the demand for money.

Frequent and large shifts in money demand created

 Trying to achieve a given inflation target in the medium

run would seem a clear improvement over trying to

 Trying to achieve a given inflation target in the short run

Measures that include not only money but other liquid

In the United States, M2 is also called broad money.

The central bank could choose M2 growth as target,

Figure 1 M2 Growth and Inflation: 10-Year Averages since 1970

 The central bank cannot always achieve the rate

of inflation it wants in the short run.

 Like all other macroeconomic relations, the

According to the Taylor rule, since it is the interest

it  i *  a( t   *) b(ut  un )

Taylor’s rule provides a way of thinking about

 If  t   *, and ut  un , then the central bank should set it

 If inflation is higher than the target ( t   *) , the central

 If unemployment is higher than the natural rate of

 Researchers looking at the behavior of both the Fed in the

 Other researchers have explored whether it is possible to

 Yet other researchers have discussed whether central banks

 In general, most central banks have now shifted to thinking in

For more information on how the Fed is organized, go

 A set of 12 Federal Reserve Districts

 The Board of Governors

 The Federal Open Market Committee (FOMC)

The money supply, H, refers to the monetary base. The

By changing reserve requirements, the Fed effectively

This instrument of monetary policy is not widely used

The Fed can also lend to banks, thereby affecting the

The set of conditions under which the Fed lends to banks

is called discount policy. The Fed lends at a rate called