PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 26 Rules versus Discretion in Monetary Policy

Copyright © 2004 South-Western. All rights reserved.26–2 Fundamental Issues 1.What are policy time lags, and how might they cause well-meaning monetary policymakers to destabilize the economy? 2. Why is monetary policy credibility a crucial factor in maintaining low inflation? 3.How might monetary policy credibility be achieved? 4.What is the evidence concerning the benefits of greater central bank independence?

Copyright © 2004 South-Western. All rights reserved.26–3 Fundamental Issues (cont’d) 5.Do countries necessarily gain from making their central banks more independent?

Copyright © 2004 South-Western. All rights reserved.26–4 Constraints on Policymakers 1.In the presence of time lags, at any given point in time policymakers have limited information about current events. 2.Policymakers are fallible human beings who face constraints on their abilities to recognize and respond appropriately to changing circumstances, particularly in light of lags in their recognition of varying circumstances. 3.Policymakers are constrained by their lack of certainty about the timing and size of the effects of their policy actions.

Copyright © 2004 South-Western. All rights reserved.26–5 Time Lags in Monetary Policy Policy time lags:  The time intervals between the need for a countercyclical monetary policy action and the ultimate effects of that action on an economic variable. Recognition lag:  The interval between the need for a countercyclical policy action and the recognition of this need by a policymaker.

Copyright © 2004 South-Western. All rights reserved.26–6 Types of Time Lags in Monetary Policy Response lag:  The interval between the recognition of a need for a countercyclical policy action and the actual implementation of the policy action. Transmission lag:  The interval between the implementation of an intended countercyclical policy and its ultimate effects on an economic variable.

Copyright © 2004 South-Western. All rights reserved.26–7 How Policy Time Lags Can Make Well-Intentioned Policy Destabilizing Figure 26–1

Copyright © 2004 South-Western. All rights reserved.26–8 Discretion versus Rules (Milton Friedman) Discretionary policymaking:  The act of responding to economic events as they occur, rather than in ways the policy-maker might previously have planned in the absence of those events. Policy rule:  A commitment to a fixed strategy no matter what happens to other economic variables.

Copyright © 2004 South-Western. All rights reserved.26–9 A Monetary Policy Game and a Theory of Inflation Game theory:  The theory of strategic interactions among individuals or institutions. Capacity output:  The real output that the economy could produce if all resources were employed to their utmost.

Copyright © 2004 South-Western. All rights reserved.26–10 Output Market Equilibrium and Policy Goals Figure 26–2

Copyright © 2004 South-Western. All rights reserved.26–11 Potential and Equilibrium Outcomes of a Monetary Policy Game Figure 26–3

Copyright © 2004 South-Western. All rights reserved.26–12 Problems of Central Bank Credibility Policy credibility:  The believability of a commitment by a central bank or governmental authority to follow specific policy rules. Time-inconsistency problem:  The policy problem that can result if a policymaker has the ability, at a future time, to alter its strategy in a way that is inconsistent both with the desires and strategies of private individuals and with its own initially announced intentions.

Copyright © 2004 South-Western. All rights reserved.26–13 Problems of Central Bank Credibility Inflation bias:  The tendency for the economy to experience continuing inflation as a result of the time- inconsistency problem of discretionary monetary policy. Self-fulfilling prophesy:  If the central bank releases a forecast predicting rising inflation, then the public’s inflation expectations will ratchet upward, thereby causing higher inflation.

Copyright © 2004 South-Western. All rights reserved.26–14 The Inflation Bias of Discretionary Monetary Policy Figure 26–4

Copyright © 2004 South-Western. All rights reserved.26–15 Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve monetary policy credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts:  A legally binding agreement between a government and a central bank official that holds the official responsible for the nation’s inflation performance.

Copyright © 2004 South-Western. All rights reserved.26–16 Making Monetary Policy Rules Credible Appoint a “conservative” central banker:  A central bank official who dislikes inflation more than the average citizen in society and who therefore is less willing to induce discretionary increases in the quantity of money in an effort to achieve short-run increases in real output.

Copyright © 2004 South-Western. All rights reserved.26–17 Annual Inflation Rates in the United States Figure 26–5 SOURCES: Economic Report of the President, 2002; Economic Indicators (various issues).

Copyright © 2004 South-Western. All rights reserved.26–18 Central Bank Independence, Average Inflation,and Inflation Variability in Major Developed Nations Figure 26–6 SOURCE: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking (May 1993): 151–162.

Copyright © 2004 South-Western. All rights reserved.26–19 Central Bank Independence, Average GDP Growth, and Variability of GDP Growth Figure 26–7 SOURCES: Carl Walsh, “Is There a Cost to Having an Independent Central Bank?” Federal Reserve Bank of San Francisco Weekly Letter, No.94-05, February 4, 1994.

Copyright © 2004 South-Western. All rights reserved.26–20 Central Bank Independence and the Inflation-Output Trade-off Figure 26–8 SOURCE: Carl Walsh, “Output-Inflation Tradeoffs and Central Bank Independence,” Federal Reserve Bank of San Francisco Weekly Letter, No.95-31,September 22, 1995.

Copyright © 2004 South-Western. All rights reserved.26–21 Central Bank Independence and Average Inflation for a Large Set of Countries Figure 26–9 SOURCE: Roberto Chang, “Policy Credibility and the Design of Central Banks,” Federal Reserve Bank of Atlanta Economic Review 83 (First Quarter, 1998): 4–15.

Copyright © 2004 South-Western. All rights reserved.26–22 Inflation Rates and Unemployment Benefit Levels in Selected Nations Figure 26–10 SOURCES: Rafael Di Tella and Robert MacCulloch, “Unemployment Benefits as a Substitute for a Conservative Central Banker,” Harvard Business School and London School of Economics, May 5, 2000.