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Chapter 23:Learning Objectives
Targets vs. Instruments of Monetary Policy
Understanding Monetary Policy: Interest Rate vs. Money Supply Control
Central Bank Performance: Political Business Cycles & Autonomy
Evaluating the Stance of Monetary Policy: the Monetary Conditions Index
Targets and Instruments of Monetary Policy
The problem of monetary policy formulation is one of understanding the relationship between operating instruments, intermediate targets, and final targets
OPERATING INSTRUMENTS are the tools of monetary policy under the control of a central bank
INTERMEDIATE TARGETS represent economic variables which react quickly and predictably to changes in the operating instruments
FINAL TARGETS are the economic variables which permit an assessment of monetary policy actions
Characterizing Monetary Policy Actions
The choice in implementing monetary policy is usually between changing the money supply (M1) or a short-term interest rate (O/N rate)
Assume a money demand model of the kind introduced in chapter 12
Introduce some uncertainty into the process by allowing some error in fluctuations around the variables of interest (interest rate and M1)
What Policies are Interesting to Look at?
Money supply targeting (FIGURE 23.3) leads to more interest rate variability than money supply variability. Was tried in the 1980s with poor results
Interest rate pegging (FIGURE 23.4) leads to money supply variability but less interest rate variability. Sometimes referred to as interest rate smoothing
Which policy is better? Assuming that less variability is better and markets are more affected by interest rate changes then smoothing of interest rates seems the best option
Figure 23.2. Instruments Control: The Basic Relationships
A. Demand for MoneyMd
t = Pt • f(yt,Rt) + ut
Md (u < 0)
R
M
Md (u = 0)
Md (u > 0)
Figure 23.2. Instruments Control: The Basic Relationships
B. Money Supply; Mst = I(Rt) • Baset + vt
Ms (v < 0)
R
M
Ms (v = 0)
Ms (v > 0)
Figure 23.3. Money Supply TargetingA. Money Supply Targeting When the Slope of Money Demand Changes
•
•
Msmin
R
M
Msmax
Md0
Rmin
Rmax
•
Md1
R’max
Figure 23.3. Money Supply Targeting
B. Money Supply Targeting and Money Demand Uncertainty
Mdmin
R
M
Mdmax
Ms0
•
•
Rmin
Rmax
Rmin
M1
Msmin
••
Mdmin
Mdmax
Figure 23.4. Interest Rate Pegging
R
M
A BR*
Mmin Mmax
Ms
Rmax
M0
Msmax
Do Central Smooth Interest Rates?
2
3
4
5
6
7
8
9
1994 1995 1996 1997 1998 1999
low high
Ove
rnight in
tere
st rate oper
ating band
Central Bank Independence and Inflation
What does independence for a central bank mean? Usually refers to instrument independence but NO goal independence
Germany and Switzerland are considered the most independent central banks
What are some important influences on the degree of central bank autonomy? Politics and fiscal policy
Is there a political business cycle? The importance of a compatible fiscal policy
Evaluating Central Bank Independence
Inflation rates in Selected Industrial Countries
-5
0
5
10
15
20
25
30
1960 1965 1970 1975 1980 1985 1990 1995 2000
AUSTRALIACANADAFRANCEJAPANSWITZERLANDUKUS
Per
cent p
er ye
ar
Year
The Inflation Control Record
Inflation has fallen in all industrialized countries since the late 1980s, not just in inflation targeting countries
The connection between central bank independence and inflation or economic growth is weak at best.
Nevertheless, most observers think it is important to make central banks statutorily independent based in the overall inflation record
Statutory Characteristics ofCentral Bank Autonomy
Monetary Policy Formulation Conflict Resolution Central Bank Objectives Term of Office Limitations on Lending to Government Accountability & Transparency
Accountability & Transparency
The Reaction Function Approach
A quantitative measure of central bank performance The reaction function approach
Changes in interest rates a function of key economic determinants (e.g., inflation, unemployment, exchange rates, foreign interest rates)
Taylor’s rule: a popular way of measuring policy Rt = * + 0.5 (- *) + 0.5 ygap + *
Taylor’s Rule for Canada
0
4
8
12
16
20
1984 1987 1990 1993 1996 1999 2002
Taylor's ruleTaylor's rule - no weight on outputOvernight money market rateU.S. federal funds rat
Per
cent
The Monetary Conditions Index
In a small open economy interest rates and exchange rate movements are related The MCI is a linear combination of interest rate and
exchange rate changes expressed in index form that recognizes this interdependence
But the MCI is also problematical because interest rates and exchange rates can be affected by demand conditions as well as by portfolio reallocation
Summary
Central banking is an “art” and involves the complex relationship between operating instruments through intermediate targets to final targets
Central banks usually have to decide whether to smooth interest rates or target money supply growth
Central bank independence and inflation performance, and possibly economic growth are believed to be related to each other and have been the focus of much policy discussions recently