Today’s plan of attack GDP release Group Project #6 Group Presentations FOMC statements Role of central banks Money – and interest Taylor rule Greenspan at the helm (mini-case)
Executive summary Good monetary policy –Balances short term objectives against long-term price stability –Opposes demand shocks, accommodates supply shocks Taylor rule –Policy rule of thumb –Serves as an anchor –Guide to bond traders: impact of output and inflation data on interest rates
GDP release (2006Q4) Advance (late Jan)3.5% Preliminary (late Feb)2.2% Final (late March – today!)2.5%
Group Project #6 What indicators did you use? What’s your forecast for growth?
Group Presentations Topic generation machine –Pick a country that interests you –Or pick a product that interests you –Think about how to tie it to something we’ve done in class Examples?
Group Presentations India: opportunity for consumer products? –Overall growth prospects –Impact on purchasing power: what products? Turkey: risk or opportunity? –Are the economy and political system stable? –If so, what opportunities are there? –Is EU membership essential? Eurozone: booming? –Despite widespread skepticism, the EZ has been one of the bright spots of the developed world –Continued growth, or trouble ahead? Opportunities?
Greg Ip, “Fed has trouble getting across nuanced message,” WJS, March 27: –When the Federal Reserve last week altered its post- meeting policy statement to soften the suggestion that it might raise interest rates, Wall Street was confused. Was the Fed signaling that a rate increase was less likely because the outlook for the economy had darkened? Or was it simply reflecting the reality that interest rates are on hold for now? –The answer to both questions is, yes.
Role of central banks What can they do? What should they do?
Federal Reserve Federal Reserve Act –The Federal Reserve System and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
ECB ECB = European Central Bank Treaty establishing the European Community: –The primary objective of [monetary policy] shall be to maintain price stability. –Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of … a high level of employment and sustainable and non- inflationary growth.
Banco Central de Argentina BCRA Act (2003): –The Argentine Central Bank is a National State self- governed institution, whose primary and fundamental mission is to preserve the value of the Argentine currency.
Ben Bernanke Testimony to Congress, November 2005: –Middle-income living standards, and poverty for that matter, are best addressed through employment growth. By maintaining low inflation and low expectations of inflation, you can create new employment.
Role of central banks How should they respond to demand shocks? Supply shocks?
Role of central banks Impact of increase in “demand” –AD shifts right/up –Short-run impact: prices up, output up –Long-run impact? –Could we offset the impact on Y? –Should we?
Role of central banks Impact of increase in productivity –AS shifts right –Short-run impact: prices down, output up –Long-run impact? –Could we offset the impact on Y? –Should we?
Money How does central bank manage the money supply? Look at balance sheets for –Treasury –Central bank –Private agents Show –Open market purchase of bonds increases money supply –Behind the scenes: interest rate adjusted to make people content to hold more money –Zimbabwe revisited
Money and interest M/P i MS/P MD = L(i,Y)
Money and interest You can choose the quantity (the money supply) Or the price (the interest rate)
Taylor rule Mathematical formula for setting the fed funds rate Why a rule? What should it depend on?
Taylor rule Rule for setting short-term interest rate i = r* + π + a 1 (π –π*) + a 2 (y–y*) –i = short term interest rate (fed funds rate) –r* = target real interest rate –π = inflation rate –π* = target inflation –y = log of real GDP –y* = log of “potential” real GDP –a 1, a 2 = (positive) parameters What do (a 1,a 2 ) mean?
Taylor rule Details: –What should r* and π* be? –What should the coefficients (a 1,a 2 ) be? –What is y*? [“potential,” “capacity,” “trend”]
Taylor rule Bond traders’ guide How do short rates respond to news about –Inflation? –Output or employment? –Central bank announcements? Long rates?
Taylor rule MonetaryP olicy Output & Inflation
Takeaways Key issues for monetary policy –Balance long-run impact on inflation against short-run impact on output –Distinguish supply and demand shocks Most central banks focus on short-term interest rates –Increase in rate corresponds to fall in money supply Taylor rule ties interest rate to inflation and output –Policy is predictable, leads to stable prices –Strong output growth and high inflation trigger increases in interest rates