Money, Banking and Financial Markets- Chapter 16

Correct monetary policy

-important for economic health

-overly expansionary mp can lead to high inflation

-too tight mp can create a recession

Overly expansionary monetary policy

- creates uncertainty

- information based on prices becomes hard to interpret

- complicated decision making for consumers, businesses and governments

- reduced economic efficiency

- obstructs economic growth

Overly contractionary monetary policy

- reduces output

- increases unemployment

- can lead to deflation

Price stability goal

Maintaining a stable price level to mitigate social and economic costs of inflation.

= low and stable inflation.

Viewed by many as most important goal of monetary policy.

Nominal anchor

A nominal variable (like inflation rate or money supply) that anchors the price level to maintain stability.

Adherence to a nominal anchor keeps the nominal variable within a narrow range and promotes price stability.

Encourages expectations for low and stable inflation.

Limits the time-inconsistency problem.

Time-inconsistency problem

Monetary policy conducted on a discretionary, day-by-day basis leads to poor long-term outcomes.

Often too expansionary, to reap short-term effects. Crippled by high inflation and unemployment in long-run.

Alternate goals of monetary policy

High employment

Output stability

Economic growth

Stable financial markets

Stable interest rates

Stability in foreign exchange markets

Full employment

Unemployment at natural rate (not zero unemployment).

Includes frictional unemployment (unemployment while looking for suitable jobs) and structural unemployment (mismatch between job requirements and skills of worker).

Should price stability be the primary goal of monetary policy?

Long-run: no conflict between price stability and other goals, no trade off between inflation and unemployment, price stability actually promotes economic growth, financial stability and interest-rate stability.

Short-run: conflict between price stability and other goals (output stability and interest-rate stability).

Hierarchical vs Dual Mandates

Ways of resolving conflicts among goals.

Hierarchical: put the price stability (long-run goal of monetary policy) first, and pursue other goals only as long as price stability is achieved

Dual mandates: pursue two objectives at the same time (price stability is one of them)

Inflation targeting

Monetary policy strategy

Consists of:

-public announcement of medium-term numerical inflation target

-institutional commitment to price stability/inflation goal

-information-inclusive approach

Advantages of inflation targeting

-reduction of time-inconsistency problem

-increased transparency

-increased accountability

-consistency with democratic principles

-improved performance

Disadvantages of inflation targeting

-too much rigidity

-potential for increased output fluctuations

-delayed signaling (lags in effect of monetary policy, inflation target doesn't send immediate signals to the public)

-low economic growth

Tools for monetary policy

Open market operations, discount rate, reserve requirements, interest rate on reserves, large-scale asset purchases, forward guidance

Policy instruments

Reserve aggregates, interest rates, may be linked to intermediate targets.

Interest rates and reserve aggregates are incompatible (must choose between).

Criteria for choosing policy instruments

Observability and measurability

Controllability

Predictable effect on goals