Money and Banking

Advanced Topics Advanced Topics in in

Monetary Policy: Monetary Policy: Central-Bank Independence

and Rules vs. Discretion

Mr. Vaughan

Central-Bank IndependenceCentral-Bank Independence

Factors making Fed independent:Factors making Fed independent:• Governors’ terms are long and staggered.• Chairman’s term overlaps President’s terms.• Reserve Bank presidents are appointed by

District boards of directors.• Funding is independent of political process—

most important factormost important factor.

How is the Fed funded?How is the Fed funded?

• Most Fed income is interest on U.S. government securities acquired through open-market operations.

• Other sources of income include:– fees received for services provided to depository

institutions– interest on discount loans to depository institutions

• The Fed pays expenses and turns the remainder over to the Treasury.

• About 95 percent of Fed earnings have been paid into the Treasury since 1914.

Central-Bank IndependenceCentral-Bank Independence

Factors making Fed dependent:Factors making Fed dependent:• President appoints Chairman and Governors.• “Low” governor salaries prompt high turnover.• Congress can amend Fed legislation.

Overall, Fed is quite independent!

Should the Fed be independent?Should the Fed be independent?

Case for independenceCase for independence::• Monetary policy will reflect the long-term

good of the country.– Inflation rate will be lower. Inflation rate will be lower.

• Monetary policy will not induce political business cycles.

• Monetary policy will impose fiscal discipline on Congress and the President.

Should the Fed be independent?Should the Fed be independent?

Case against independenceCase against independence::• Fed structure is anti-democratic.

• Fed may pursue its own interest, not that of the country.

• Fed performance will be dependent on personalities (and, thus, inconsistent).

• Fed structure will hinder coordination of monetary and fiscal policy.

Central-Bank Independence:Central-Bank Independence: Cross-Country EvidenceCross-Country Evidence

Central bank independence produces(?) lower inflation rates.Central bank independence produces(?) lower inflation rates.

Rules vs. DiscretionRules vs. Discretion

Definitions:Definitions: “Rule-type policymaking involves implementation in each period (or in each case) of a formula designed to apply to periods (or cases) in general, while discretionary policymaking involves freshly made decisions in each period or case.”

Bennett McCallumBennett McCallumMonetary Economics:

Theory and Policy

Case for DiscretionCase for Discretion

Discretion gives policymakers maximum flexibility to react creatively to new policy problems.

– Example:Example: Fed response to 9/11

Activist vs. Non-activist RulesActivist vs. Non-activist Rules

• Non-Activist RuleNon-Activist Rule:: No feedback from economy

Example: M2t = 0.03 (i.e., 3% per annum growth in all states of the world)

• Activist RuleActivist Rule:: includes feedback from economy

Example: M2t = 0.03 + (unemployment ratet-1 – 0.05)

Old Case for RulesOld Case for Rules

1.1. FriedmanFriedman:: Long and variable lags make “fine tuning” impossible.

• Recognition lag• Action lag• Impact lag

2.2. BuchananBuchanan:: Public-choice angle• Without rules, agency problem develops (i.e.,

central bank will pursue its interest at expense of general public)

New Case for Rules:New Case for Rules:Time InconsistencyTime Inconsistency

Discretionary policy has an inflationary biasDiscretionary policy has an inflationary bias.. • Policymakers play game against public.• Public understands policymakers’ incentives.• Without rules, policymaker is tempted to say one thing

and do another; public knows this and discounts “cheap talk.”

• End resultEnd result:: Higher inflation, no gain in unemployment.

To see this, we must take a detour into NAIRU!

Basic StoryBasic Story::• In the long run, unemployment is moored at “natural

rate.”• Unexpectedly high money growth can temporarily

reduce unemployment rate below natural rate. • Only repeated money surprises can keep

unemployment rate below natural rate.

NoteNote: NAIRU is just another name for “natural rate.”

NAIRU FrameworkNAIRU FrameworkNNon-on-AAccelarating ccelarating IInflation nflation RRate of ate of UUnemploymentnemployment

Even when economy is growing at long-term potential, some people remain unemployed.

• Frictional UnemploymentFrictional Unemployment:: due to imperfect information in the labor market

• Structural UnemploymentStructural Unemployment:: due to job/skill mismatch

NAIRU Framework:NAIRU Framework:Natural Rate of UnemploymentNatural Rate of Unemployment

NAIRU FactsNAIRU Facts::• Equilibrium level of unemployment • Not observable • Not constant over time

(affected by demographics, labor market frictions)(affected by demographics, labor market frictions)

• Currently thought to be just above 5%.

NAIRU Framework:NAIRU Framework:Natural Rate of UnemploymentNatural Rate of Unemployment

Point A: •Inflation fully expected and reflected in nominal wage growth.

Infactual = Infexpected = Inf1

•Actual unemployment rate = Natural rate of unemployment

Unemployment Rate

Inflation Rate

Inf1

Un=U1

A

NAIRU Framework:NAIRU Framework:In PicturesIn Pictures

B

U2

Inf2Now, central bank unexpectedly speeds up monetary growth. •Economy perks up.

•Unemployment falls to U2.

•Inflation rises to inf2 .

Unemployment Rate

Inflation Rate

Inf1

A

NAIRU FrameworkNAIRU FrameworkIn PicturesIn Pictures

Un=U1

Why does unemployment fall?Why does unemployment fall?• Workers agreed to nominal wage contracts expecting

inflation to be infinf11.

• Inflation rate ends up somewhat higher at infinf22.

• Firms increase demand for labor because actualactual real wage has fallen.

NAIRU FrameworkNAIRU Framework

NAIRU framework can explain short-run non-neutrality of money!

Drop in unemployment is temporaryDrop in unemployment is temporary::• Over time, workers figure out inflation rate is higher /

real wages are lower than expected. • Workers negotiate new nominal wage contacts based on

new inflation ratio (inf(inf22)).

• Absent additional stimulus, unemployment rate returns to natural rate.

What happens in long run?What happens in long run?

Money still neutral in long run!

B

U2

Inf2

Unemployment rate

Inflation Rate

Inf1 A

The NAIRU Framework:The NAIRU Framework:In PicturesIn Pictures

Un=U1

C Result: After adjustment of inflation expectations, unemployment drifts back to the natural rate (Point C), but with a new permanently higher inflation rate (inf2).

In shortIn short::• Only repeated inflation surprises (accelerating

inflation) will keep unemployment below natural rate.

• Misguided attempts to peg unemployment rate below natural rate led to accelerating inflation and rising nominal interest rates in 1970s.

NAIRU FrameworkNAIRU Framework

Can’t fool all of the people all of the timeCan’t fool all of the people all of the time::Central banks with discretion have incentive to renege on

commitments to price stability. After public has formed expectations of inflation, central bank can

increase monetary growth to reduce unemployment.

Public will anticipate this possibility and form expectations accordingly.

Result:Result: Inflation will be higher because central bank must accommodate the expected policy (why?),(why?), but unemployment remains at natural rate.

NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle

Inf2

Unemployment Rate

Inflation Rate

Inf1 A

Un=U1

CResult: In the end, inflation will be higher but unemployment will be no lower (point C).

NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle

Policy under discretion produces results in each period Policy under discretion produces results in each period inconsistent with long-run policy goals (time-inconsistency problem).inconsistent with long-run policy goals (time-inconsistency problem).

Inf2

Unemployment rate

Inflation Rate

Inf1 A

Un=U1

C Result: Only binding rule, can make central bank’s commitment to price stability credible and keep inflation at point A.

NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle

Note result (inflationary bias) does not depend onNote result (inflationary bias) does not depend on::Imperfect knowledge

Imperfect monetary tools

Agency problems (differences in public’s and central bank’s objective functions).

NAIRU Framework:NAIRU Framework:Time-Inconsistency AngleTime-Inconsistency Angle

Rules vs. Discretion:Rules vs. Discretion:The EvidenceThe Evidence

Rules lead to lower inflation.Rules lead to lower inflation.• U.S. on gold standard (type of rule): bundle of goods

costing $1 in 1776 cost $1.19 in 1945.• U.S. with no rule: bundle of goods costs $1.00 in March

1953 (Treasury-Fed Accord, discretionary policy) would cost $8.00 today (March 2009) .

Discretion Discretion maymay lead to greater economic stability. lead to greater economic stability.• Many economists believe U.S. business-cycle

fluctuations have been milder since World War II.

A Closer Look at Activist Rules:A Closer Look at Activist Rules:The Taylor RuleThe Taylor Rule

Fed funds rate target = Fed funds rate target = inflation rate + equilibrium real fed funds rateinflation rate + equilibrium real fed funds rate+ ½ (inflation gap) + ½ (output gap) + ½ (inflation gap) + ½ (output gap)

where:• Equilibrium real fed funds rate = neutral rate• Inflation rate = current observed rate• Inflation target = set by policy makers• Inflation gap = current inflation rate – inflation target• Output gap = percentage deviation of current real

GDP from estimate of potential GDP

A Closer Look at Activist Rules:A Closer Look at Activist Rules:The Taylor RuleThe Taylor Rule

Example:Example:• Equilibrium real fed funds rate = 2%• Inflation target = 2%• Current inflation rate = 3%• Inflation gap = current inflation (3%) – inflation target (2%)• Output gap = Current real GDP is 1% above potential.

Fed funds rate target = Fed funds rate target =

(3%) + (2%) + ½ (1%) + ½ (1%)(3%) + (2%) + ½ (1%) + ½ (1%) = 6% = 6%

Time-Inconsistency Problem Time-Inconsistency Problem Other SolutionsOther Solutions

Besides rules…Besides rules…• Reputation building• Incentive-compatible contracts for central

bankers• “Conservative” central bankers

Inflation Targeting:Inflation Targeting:A Middle Ground?A Middle Ground?

• Not really a rule; not really discretion either.• Basic features:

– Central bank announces official inflation target– Central bank explicitly acknowledges that low and stable

inflation is overriding goal of monetary policy.– Central bank becomes more transparent and more

communicative with public.– Central bank held accountable for attaining inflation

targets.

• Basic Flaw:Basic Flaw: Can you really hold central bank accountable for an inflation target?

How does the Fed set policy?How does the Fed set policy?

Taylor rule describes policy under Greenspan fairly well.Taylor rule describes policy under Greenspan fairly well.

Taylor Rule and Fed Funds Rate1960-2003

Questions over:

Advanced Topics Advanced Topics in in

Monetary Policy: Monetary Policy: Central-Bank Independence

and Rules vs. Discretion?

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