Chapter 23:Learning Objectives

Targets vs. Instruments of Monetary Policy

Understanding Monetary Policy: Interest Rate vs. Money Supply Control

Central Bank Performance: Political Business Cycles & Autonomy

Evaluating the Stance of Monetary Policy: the Monetary Conditions Index

Targets and Instruments of Monetary Policy

The problem of monetary policy formulation is one of understanding the relationship between operating instruments, intermediate targets, and final targets

OPERATING INSTRUMENTS are the tools of monetary policy under the control of a central bank

INTERMEDIATE TARGETS represent economic variables which react quickly and predictably to changes in the operating instruments

FINAL TARGETS are the economic variables which permit an assessment of monetary policy actions

Characterizing Monetary Policy Actions

The choice in implementing monetary policy is usually between changing the money supply (M1) or a short-term interest rate (O/N rate)

Assume a money demand model of the kind introduced in chapter 12

Introduce some uncertainty into the process by allowing some error in fluctuations around the variables of interest (interest rate and M1)

What Policies are Interesting to Look at?

Money supply targeting (FIGURE 23.3) leads to more interest rate variability than money supply variability. Was tried in the 1980s with poor results

Interest rate pegging (FIGURE 23.4) leads to money supply variability but less interest rate variability. Sometimes referred to as interest rate smoothing

Which policy is better? Assuming that less variability is better and markets are more affected by interest rate changes then smoothing of interest rates seems the best option

Figure 23.2. Instruments Control: The Basic Relationships

A. Demand for MoneyMd

t = Pt • f(yt,Rt) + ut

Md (u < 0)

R

M

Md (u = 0)

Md (u > 0)

Figure 23.2. Instruments Control: The Basic Relationships

B. Money Supply; Mst = I(Rt) • Baset + vt

Ms (v < 0)

R

M

Ms (v = 0)

Ms (v > 0)

Figure 23.3. Money Supply TargetingA. Money Supply Targeting When the Slope of Money Demand Changes

•

•

Msmin

R

M

Msmax

Md0

Rmin

Rmax

•

Md1

R’max

Figure 23.3. Money Supply Targeting

B. Money Supply Targeting and Money Demand Uncertainty

Mdmin

R

M

Mdmax

Ms0

•

•

Rmin

Rmax

Rmin

M1

Msmin

••

Mdmin

Mdmax

Figure 23.4. Interest Rate Pegging

R

M

A BR*

Mmin Mmax

Ms

Rmax

M0

Msmax

Do Central Smooth Interest Rates?

2

3

4

5

6

7

8

9

1994 1995 1996 1997 1998 1999

low high

Ove

rnight in

tere

st rate oper

ating band

Central Bank Independence and Inflation

What does independence for a central bank mean? Usually refers to instrument independence but NO goal independence

Germany and Switzerland are considered the most independent central banks

What are some important influences on the degree of central bank autonomy? Politics and fiscal policy

Is there a political business cycle? The importance of a compatible fiscal policy

Evaluating Central Bank Independence

Inflation rates in Selected Industrial Countries

-5

0

5

10

15

20

25

30

1960 1965 1970 1975 1980 1985 1990 1995 2000

AUSTRALIACANADAFRANCEJAPANSWITZERLANDUKUS

Per

cent p

er ye

ar

Year

The Inflation Control Record

Inflation has fallen in all industrialized countries since the late 1980s, not just in inflation targeting countries

The connection between central bank independence and inflation or economic growth is weak at best.

Nevertheless, most observers think it is important to make central banks statutorily independent based in the overall inflation record

Statutory Characteristics ofCentral Bank Autonomy

Monetary Policy Formulation Conflict Resolution Central Bank Objectives Term of Office Limitations on Lending to Government Accountability & Transparency

Accountability & Transparency

The Reaction Function Approach

A quantitative measure of central bank performance The reaction function approach

Changes in interest rates a function of key economic determinants (e.g., inflation, unemployment, exchange rates, foreign interest rates)

Taylor’s rule: a popular way of measuring policy Rt = * + 0.5 (- *) + 0.5 ygap + *

Taylor’s Rule for Canada

0

4

8

12

16

20

1984 1987 1990 1993 1996 1999 2002

Taylor's ruleTaylor's rule - no weight on outputOvernight money market rateU.S. federal funds rat

Per

cent

The Monetary Conditions Index

In a small open economy interest rates and exchange rate movements are related The MCI is a linear combination of interest rate and

exchange rate changes expressed in index form that recognizes this interdependence

But the MCI is also problematical because interest rates and exchange rates can be affected by demand conditions as well as by portfolio reallocation

Summary

Central banking is an “art” and involves the complex relationship between operating instruments through intermediate targets to final targets

Central banks usually have to decide whether to smooth interest rates or target money supply growth

Central bank independence and inflation performance, and possibly economic growth are believed to be related to each other and have been the focus of much policy discussions recently