Chapter 17: Monetary Policy Targets and Goals Chapter Objectives Explain why the Fed was generally so ineffective before the late 1980s. Explain why macroeconomic volatility declined from the late 1980s until List the trade-offs that central banks face and describe how they confront them. Define monetary targeting and explain why it succeeded in some countries and failed in others. Define inflation targeting and explain its importance. Provide and use the Taylor Rule and explain its importance.

2. Central Bank Goal Trade-offs Maximize price stability Minimize unemployment Primary objective of Central banks

2. Central Bank Goal Tradeoffs Unemployment Frictionalis a little unemployment; allows the labor market to function smoothly Structuralwhen workers’ skills do not match job requirements; inevitable in a dynamic economy As structural unemployment increased in the United States, education improved somewhat Fed shoots for natural rate of unemployment—could be 5 percent, give or take

3. Central Bank Targets Goal Maximize price stability Minimize unemployment Hold the line (no ∆) Tighten (increase i, decrease or slow the growth of MS) Ease (lower i, increase MS) Tools Open market operations Discount rate Reserve requirement

3. Central Bank Targets Target: Aggregate MS (M 1 or M 2 ) Problems Time inconsistency Time lags between policy implementation and real- world effects Difficulty predicting the importance of specific aggregates as a determinant of interest rates and the price level Disjoint between tools and targets

3. Central Bank Targets Target: Inflation Frees central banks to do whatever it takes to keep prices in check Forces central banks to use all available information and not just monetary statistics Makes central banks more accountable – success or failure is easily monitored

4. The Taylor Rule “ What is a monetary policy rule? At its most basic level, it is a contingency plan that lays out how monetary policy decisions are, or should be, made. Let me start with the example of the Taylor rule... Originally the rule was meant to be normative: a recommendation of what the Fed should do. It was derived from monetary theory, or more precisely from optimization exercises using new dynamic stochastic monetary models with rational expectations and price rigidities.” -- John Taylor, the Adam Smith Lecture, Annual Meeting of the National Association of Business Economics September 10, 2007

4. The Taylor Rule The Taylor Rule ff t = π + ff* r + ½(π gap) + ½(Y gap) ff t = federal funds target π = inflation ff* r = the real equilibrium fed funds rate π gap = inflation gap (π – π target) Y gap = output gap (actual output [e.g. GDP] - output potential)

4. The Taylor Rule The Taylor Rule ff t = π + ff* r + ½(π gap) + ½(Y gap) If π gap > 0, then π > π target, then ff t > ff* r Or, if inflation is greater than target inflation, the target fed funds rate should be raised. If π gap < 0, then π < π target, then ff t < ff* r Or, if inflation is less than target inflation, the target Fed Funds rate should be lowered.

4. The Taylor Rule The Taylor Rule ff t = π + ff* r + ½(π gap) + ½(Y gap) Is counter-cyclical: If inflation or output indicates overheating, the target fed funds rate should be raised to slow growth. Or If deflation or excess capacity indicates sluggishness, the target fed funds rate should be lowered to stimulate growth.

4. The Taylor Rule The Taylor Rule ff t = π + ff* r + ½(π gap) + ½(Y gap) is counter-cyclical and accounts for two important Federal Reserve goals: price stability and employment/output. Since 1960, when the ff t and the Taylor Rule were closely matched, the economy has had low inflation and strong growth.