17.4 The Taylor Rule #Notebook

17.4 The Taylor Rule #Notebook

fft = π + ff*r + 1 ⁄ 2(π gap) + 1 ⁄ 2(Y gap)

Federal funds target = inflation + the real equilibrium fed funds rate + 1/2 inflation gap +1/2 output gap

fft = 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, GDP − output potential)

Globalization makes it increasingly important for the Fed and other central banks to look at world inflation and output levels to get domestic monetary policy right.

Foreign exchange rates can also flummox central bankers and their policies. Increasing or decreasing interest rates will cause a currency to appreciate or depreciate in currency markets. 

Because the value of a currency directly affects foreign trade, when a currency is strong or weak relative to other currencies, imports will be stimulated or contracted because foreign goods will be cheap or expensive.

Some countries with economies heavily dependent on foreign trade have to be extremely careful about the value of their currencies.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

17.3 Central Bank Targets #Notebook

17.3 Central Bank Targets #Notebook

TOOLS → SET TARGET → SET GOAL

Time inconsistency problem, The inability over time to follow a good plan consistently. Like a wayward dieter or a lazy student, they overshot their targets time and time again. 

Monetary targets did not always equate to the goals. There are long lags between policy implementation and real-world effects. The situation is changing over time, and nearly impossible to predict. 

Central banks cannot control both an interest rate and a monetary aggregate at the same time. 

Central banks can control interest rate or MS, but not both

If the central bank leaves the supply of money fixed, changes in the demand for money will make the interest rate jiggle up and down. It can only keep interest rates fixed by changing the money supply. However, with the monetary supply moving round and round, up and down, it became difficult to hit monetary targets.

If central banks adopt explicit inflation targets, the result will be lower employment and output in the short run. As inflation expectations spread, an extended period begins, and then high employment.

Inflation targeting frees central bankers to do whatever it takes to keep prices in check, to do it with more useful information, not just monetary statistics. That makes the policies more sensible to the public because anyone can feel it.

However, if a country like New Zealand, its legislature can oust what central banker is doing by law, it makes the central bank less independent. But, if it legislature uses the punishment only to oust incompetent or corrupt central bankers, it should be salutary. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

17.2 Central Bank Goal Trade-offs #Notebook

17.2 Central Bank Goal Trade-offs #Notebook

Central banks often get themselves in a dilemma, in which price stability, inflation control, economic growth, and employment. Although in the long run, the two goals are compatible, they sometimes are not in the short run.

Central banks have to make hard decisions.....

Raise interest rates or slow or even stop MS growth to stave off inflation? 

Or, decrease interest rates, speed up MS growth to induce companies and consumers to borrow to stoke employment and growth? 

When central banks act as a lender of last resort to restore stability to the financial system, they create a time inconsistency problem and moral hazard. Business owners and bankers take on extra risks since they think they will get free favors while difficult times.

However, a little frictional unemployment is a good thing because it allows the labor market to function more smoothly. Frictional unemployment naturally occurs, even in a growing, stable economy. Workers choosing to leave their jobs in search of new ones. 

Structural unemployment, when workers’ skills do not match job requirements, is not such a good thing, but is probably inevitable in a dynamic economy saddled with a weak educational system. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

17.1 Monetary Policy Targets and Goals

17.1 Monetary Policy Targets and Goals #Notebook

The economies tend to cycle through periods of boom and bust, of expansion and contraction. 

The Fed used to exacerbate these cycles by making the highs of the business cycle higher and the lows lower.

The postwar recession hurt the Fed’s revenues because the volume of rediscounts shrank.

Roosevelt Recession of 1937–1938 was caused by raising the reserve requirement, a new policy placed in its hands by FDR and his New Dealers in the Banking Act of 1935.

During World War II, the Fed wasn’t very independent. After the war, demand increased, coupled with quantity rationing, the floodgates of inflation opened. 

Basically, wealth would increase (decrease), driving interest rates up (down), inducing the Fed to buy (sell) bonds, thereby increasing (decreasing) MB and thus the money supply (MS). 

However, if interest rates rose or bond prices declined due to an increase in inflation, the Fed would also buy bonds to support their prices, thereby increasing the money supply and higher inflation. 

When the Great Inflation began in the late 1960s, nominal interest rates rose above those set by the Fed, and credit crunches resulted because the quantity demanded exceeds the quantity supplied by the market. 

Banks made fewer loans because they couldn’t attract the deposits they needed. During high interest rates, entrepreneurs couldn’t obtain financing for good business ideas, decreasing economic activity. 

By the late 1980s, the Fed, under Alan Greenspan began to engage in anti-cyclical policies, raising the federal funds rate before inflation became a problem and by lowering the federal funds rate at the first sign of recession. Since then, the natural swings of the macroeconomy have been much more docile than hitherto, until the crisis of 2007–2008. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.