what should central banks do monetary policy goals, strategy and tactics

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Chapter 18
What Should Central Banks Do?
Monetary Policy Goals, Strategy
and Tactics
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Monetary Targeting Strategy
•
Central bank announces it will achieve a
certain value (the target) of the annual growth
rate of a monetary aggregate.
•
Central bank then is accountable for hitting the
target
•
Monetary targeting was adopted by several
countries: Germany, Switzerland, Canada, the
U.K., Japan and the U.S.
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Monetary Targeting
•
Flexible, transparent, accountable

•
Advantages
–
Almost immediate signals help fix inflation expectations
and produce less inflation
–
Almost immediate accountability
•
Disadvantages
–
Must be a strong and reliable relationship between the
goal variable and the targeted monetary aggregate
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Inflation Targeting
•
Public announcement of medium-term numerical
target for inflation
•
Institutional commitment to price stability as the
primary, long-run goal of monetary policy and a
commitment to achieve the inflation goal
•
Information-inclusive approach in which many
variables are used in making decisions
•
Increased transparency of the strategy
•

Increased accountability of the central bank
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Inflation Targeting in New Zealand
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Reserve Bank of New Zealand Act 1989
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Minster of Finance and Governor of Reserve Bank to
make Policy Targets Agreement
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Governor of the Reserve Bank was held accountable
for the success of monetary policy.
•
Inflation brought down from above 5% to below 2%
by the end of 1992
•
Since 1992 NZ growth rate has been high and
unemployment declined significantly
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Inflation Targeting In Canada
•
In 1991, the Minister of Finance and the Governor of the
Bank of Canada established formal inflation targets
•
The target range was 2-4% by the end of 1992, 1.5-3%

by June 1994 and 1-3% by December 1996
•
After a new government took office in 1993, the target
was set at 1-3% and has been kept at this level ever
since
•
Canadian inflation has fallen dramatically since the
adoption of targets, falling from 5% in 1991, to zero in
1995 and between 1-2% in the late 1990’s
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Inflation Targeting in the U.K.
•
Adopted inflation target as nominal anchor in
October 1992
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Inflation target was initially set at 1-4%
•
May 1997 inflation target set at 2.5% and Bank of
England was given power to set interest rates
(provided independence)
•
December 2003, target was changed to 2%.
•
Growth in U.K. economy has been strong leading to
reduction in the unemployment rate
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Inflation Rates and Inflation Targets
Figure 18-1(a)
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Inflation Rates and Inflation Targets
Figure 18-1(b)
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Inflation Rates and Inflation Targets
Figure 18-1(c)
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Inflation Targeting
•
Advantages
–
Does not rely on one variable to achieve target
–
Easily understood
–
Reduces potential of falling in
time-inconsistency trap

–
Stresses transparency and accountability
•
Disadvantages
–
Delayed signaling
–
Too much rigidity
–
Potential for increased output fluctuations
–
Low economic growth
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Monetary Implicit Nominal Anchor
•
U.S. does not use explicit nominal anchor.
•
Involves forward looking behaviour , careful
monitoring for signs of future inflation coupled
with periodic “pre-emptive strikes” by
monetary policy against threat of inflation
•
Monetary policy has long lags
•
Cannot wait to respond until inflation has
begun.
•

Needs to be forward-looking and pre-emptive
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Advantages and Disadvantages to the U.S
Approach
•
Does not rely on a stable money-inflation
relationship
•
Discourages overly expansionary monetary policy
•
Lack of transparency
•
Uncertainty leads to unnecessary volatility in
financial markets, doubt among producers/general
public
•
Strong dependence on the preferences, skills and
trustworthiness of the central bank staff
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Summary of Advantages and Disadvantages of
Different Monetary Policy Strategies
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Tactics: Choosing the Policy Instrument
•
Tools
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Open market operation
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Government deposit shifting
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Last resort lending
–
Overnight interest rate
•
Policy instrument (operating instrument)
–
Reserve aggregates
–
Interest rates
–
May be linked to an intermediate target
•
Interest-rate and aggregate targets
are incompatible
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Linkages Between Central Bank Tools, Policy
Instruments, Intermediate Targets and Goals
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The Price Stability Goal
•
Low and stable inflation
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Inflation
–
Creates uncertainty and difficulty in planning for
future
–
Lowers economic growth
–
Strains social fabric
•
Nominal anchor
•
Time-inconsistency problem
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Result of Targeting Non-borrowed Reserves
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Result of Targeting Overnight Funds
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Criteria for Choosing the Policy Instrument
•
Observability and Measurability
•
Controllability
•
Predictable effect on Goals
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The Taylor Rule, NAIRU, and the Phillips
Curve
Overnight interest rate = inflation rate + equilibrium
overnight rate + ½ (inflation gap) + ½ (output gap)
•
An inflation gap and an output gap
–
Stabilizing real output is an important concern
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Output gap is an indicator of future inflation as shown by
Phillips curve
•
NAIRU
–
Rate of unemployment at which there is no tendency for
inflation to change

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Taylor Rule and the Overnight Interest Rate
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Central Bank’s Response to Asset-Price
Bubbles
•
Two Types of Asset-Price Bubbles
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Credit-Driven Bubbles
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Bubbles Driven by Irrational Exuberance
•
Central Banks Response to Bubbles
•
Monetary Policy and Asset-Price Bubbles
•
Other Appropriate Policy Responses
–
Macroprudential regulation
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Bank of Canada Historical Perspective: The

Early Years
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Bretton Wood (1945-1970s)
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1971 flexible exchange rate with the U.S
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Expansionary MP in 1970s lead to high inflation
•
Rise of monetarism
•
CB adopted key monetary aggregates as
intermediate targets of monetary policy
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Interest Rates - Canada and U.S., 1941-2009