Chapter 9: Monetary Policy Strategy & Tactics PDF

Chapter 9: The Conduct of Monetary Policy: Strategy and Tactics Money & Banking  Ch09- The Conduct of Monetary Policy: Strategy and Tactics Table of Contents Objectives..........................................

Chapter 9: The Conduct of Monetary Policy: Strategy and Tactics Money & Banking  Ch09- The Conduct of Monetary Policy: Strategy and Tactics Table of Contents Objectives.................................................................................................................................. 3 The Price Stability Goal and the Nominal Anchor.................................................................... 4 Other 5 Goals of Monetary Policy............................................................................................. 6 References................................................................................................................................. 9 2  Ch09- The Conduct of Monetary Policy: Strategy and Tactics Objectives By the end of this chapter the student is expected to be able to: Define and recognize the importance of a nominal anchor. Identify the six potential goals that monetary policymakers may pursue. 3  Ch09- The Conduct of Monetary Policy: Strategy and Tactics The Price Stability Goal and the Nominal Anchor Over the past few decades, policymakers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy. Price stability, which central bankers define as low and stable inflation, is increasingly viewed as the most important goal of monetary policy. Price stability is desirable because a rise in the price level (inflation) creates uncertainty that might hamper economic growth and lead to a less efficient financial center. Inflation also makes it difficult to plan for the future. The Role of a Nominal Anchor: Because price stability is so crucial to the long-term health of the economy, a central element in successful monetary policy is the use of a nominal anchor: a nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability. A nominal anchor is a nominal variable within a narrow range that promotes price stability by directly promoting low and stable inflation expectations. Another reason for a nominal anchor`s importance is that it can limit the time inconsistency problem, in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-term outcomes. 4  Ch09- The Conduct of Monetary Policy: Strategy and Tactics The time inconsistency problem: The time inconsistency problem is something we deal with continually in everyday life. We often have a plan that we know will produce a good outcome in the long run, but when tomorrow comes, we just can’t help ourselves and we renege on our plan because doing so has short- term gains. Monetary policymakers also face the time inconsistency problem. They are always tempted to pursue a discretionary monetary policy that is more expansionary than firms or people expect because such a policy would boost economic output (or lower unemployment) in the short run. The best policy, however, is not to pursue expansionary policy, because decisions about wages and prices reflect workers’ and firms` expectations about policy; when they see a central bank pursuing expansionary policy, workers and firms will raise their expectations about inflation, driving wages and prices up. The rise in wages and prices will lead to higher output on average. So, a nominal anchor is like a behavior rule. It can help prevent the time inconsistency problem in monetary policy by providing an expected constraint on discretionary policy. 5  Ch09- The Conduct of Monetary Policy: Strategy and Tactics Other 5 Goals of Monetary Policy Five other goals of Monetary Policy are continually mentioned by the central bank: 1. High employment and output stability: high employment is a worthy goal for two main reasons: 1. The alternative situation (high unemployment) causes much human misery 2. When unemployment is high the economy has both idle workers and idle resources resulting in a loss of output (lower GDP) This goal of high employment is not an unemployment level of zero but a level above zero that is consistent with full employment. This level is called the natural rate of unemployment. The high employment goal can be thought of in another way. Because of the level of economic activity in the economy, a particular level of output is produced at the natural rate of unemployment, which naturally enough is referred to as the natural rate of output but is more often referred to as potential output. Trying to achieve the goal of high employment thus means that central banks should try to move the level of output toward the natural rate of output. In other words, they should try to stabilize the level of output around its natural rate. 6  Ch09- The Conduct of Monetary Policy: Strategy and Tactics 2. Economic growth: Businesses' steady economic growth is closely related to the high- employment goal because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it doesn’t pay for a firm to invest in additional plants and equipment. Policies can be aimed specifically at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. 3. Stability of financial markets: Financial Crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities and can lead to a sharp contraction in economic activity. The promotion of a more stable financial system, in which financial crises are avoided, is thus an important goal for a central bank. 4. Interest-rate stability: Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. 7  Ch09- The Conduct of Monetary Policy: Strategy and Tactics 5. Stability in foreign exchange markets: With the increasing importance of international trade to the different economies, the value of the (dollar) relative to other currencies has become a major consideration for the Federal Reserve. Preventing large changes in the value of the(dollar)makes it easier for firms and individuals purchasing or selling goods abroad to plan ahead. Stabilizing extreme movements in the value of the (dollar) in foreign exchange markets is thus an important goal of monetary policy. 8  Ch09- The Conduct of Monetary Policy: Strategy and Tactics References Mishkin, F. S. (2016). The Economics of Money, Banking, and Financial Markets (11th ed.). Pearson. ISBN-13: 978-1292094182, ISBN-10: 1292094184. 9