Monetarism & Monetary Targeting Rules not discretion!! End monetary mischief!!! MV = PY … automatic stabilization??? M1? M2?? Innovations Does targeting M change V??? –Fed began to announce targets for money supply growth in –Paul Volker (1979) focused on nonborrowed reserves –Greenspan (July 1993)announced the Fed would not use any monetary aggregates to guide monetary policy Nominal GDP targeting??? PY –Automatic stabilization???

Inflation Targeting Bernanke, Laubach, Mishkin, Posen (1999) NZ (1990), CN (1991), UK (1992), S, Su (1993)…Au,E,Is,Chile,Brazil Announcement of medium-term numerical target for π Institutional commitment to price stability as primary, long-run goal of monetary policy Information-inclusive approach in which many variables are used in making decisions Increased transparency of the strategy –π understood by all … B of E Inflation Report Increased accountability of central bank “Constrained discretion” Flexible: don’t ignore things other than inflation

FIGURE 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2008 Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999), updates from the same sources, and

Inflation Targeting Advantages –Does not rely on one variable to achieve target –Easily understood –Reduces time-inconsistency risk –Stresses transparency and accountability Disadvantages –Delayed signaling –Too much rigidity??? – Really not –Potential for increased output fluctuations –Low economic growth during disinflation

Monetary Policy with an Implicit Nominal Anchor … The Greenspan Standard No explicit nominal anchor Forward looking behavior and periodic “preemptive strikes” –Prevent inflation from getting started. Bubbles and The Greenspan Put –1987 … ok –1998 LTCM … ok –2000 dot.com … ok –2007 housing bubble … ouch!!!

Tools –Open market operation –Reserve requirements –Discount rate Policy instrument (operating instrument) –Reserve aggregates –Interest rates Interest-rate and aggregate targets are incompatible (must chose one or the other).

Targeting Nonborrowed Reserves (a monetary aggregate) Targeting the Federal Funds Rate

The Taylor Rule, NAIRU, and the Phillips Curve An inflation gap and an output gap Stabilizing real output is an important concern Output gap is an indicator of future inflation (Phillips Curve) NAIRU –Rate of unemployment at which there is no tendency for inflation to change Fed policy stance, expectations and real interest rates i real = i – π e Expectations hypothesis: Expected short-rates  long rates i ff target = 2% + π +.5(π – π*) +.5(Y – Y fe )

The Taylor Rule for the Federal Funds Rate 1970–2008 Source: Federal Reserve: and author’s calculations.

Central Bank Response to Asset Price Bubbles: Lessons From the Subprime Triggered Crisis –Credit-driven bubbles Subprime triggered financial crisis –Bubbles driven solely by irrational exuberance Bubbles are easier to identify when asset prices and credit are increasing rapidly at same time. –The “Greenspan Put” Can’t judge when it’s a bubble and when it’s a “new era” –Include asset prices in measure of inflation? Raising rates to prick a bubble can damage macroeconomy Clean up after the bubble bursts. –Mishkin’s preference: “Macroprudential regulation” Oppose feedbacks from credit - to asset prices - to credit Raise credit standards … in shadow banking system too?

Historical Perspective I Discount policy and the real bills doctrine Discovery of open market operations The Great Depression Reserve requirements as a policy tool –Thomas Amendment to the Agricultural Adjustment Act of 1933 War finance and the pegging of interest rates

Historical Perspective II Targeting money market conditions –Procyclical monetary policy Targeting monetary aggregates New Fed operating procedures –De-emphasis of federal funds rate De-emphasis of monetary aggregates –Borrowed reserves target Federal funds targeting again –Greater transparency

Historical Perspective III Preemptive strikes against inflation Preemptive strikes against economic downturns and financial disruptions –LTCM –Enron –Subprime meltdown International policy coordination