Money and Banking

1. Advanced Topics in Monetary Policy: Central-Bank Independence and Rules vs. Discretion Money and Banking Mr. Vaughan

2. Central-Bank Independence 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 factor.

3. 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.

4. Central-Bank Independence 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!

5. Should the Fed be independent? Case for independence: • Monetary policy will reflect the long-term good of the country. • Inflation rate will be lower. • Monetary policy will not induce political business cycles. • Monetary policy will impose fiscal discipline on Congress and the President.

6. Should the Fed be independent? Case 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.

7. Central-Bank Independence:Cross-Country Evidence Central bank independence produces(?) lower inflation rates.

8. Rules vs. Discretion 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 McCallum Monetary Economics: Theory and Policy

9. Case for Discretion Discretion gives policymakers maximum flexibility to react creatively to new policy problems. • Example: Fed response to 9/11

10. Activist vs. Non-activist Rules • Non-Activist Rule: No feedback from economy Example: M2t = 0.03 (i.e., 3% per annum growth in all states of the world) • Activist Rule: includes feedback from economy Example: M2t = 0.03 + (unemployment ratet-1 – 0.05)

11. Old Case for Rules • Friedman: Long and variable lags make “fine tuning” impossible. • Recognition lag • Action lag • Impact lag • Buchanan: Public-choice angle • Without rules, agency problem develops (i.e., central bank will pursue its interest at expense of general public)

12. New Case for Rules:Time Inconsistency Discretionary 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 result: Higher inflation, no gain in unemployment. To see this, we must take a detour into NAIRU!

13. NAIRU FrameworkNon-AccelaratingInflation Rate of Unemployment Basic 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. Note: NAIRU is just another name for “natural rate.”

14. NAIRU Framework:Natural Rate of Unemployment Even when economy is growing at long-term potential, some people remain unemployed. • Frictional Unemployment: due to imperfect information in the labor market • Structural Unemployment: due to job/skill mismatch

15. NAIRU Framework:Natural Rate of Unemployment NAIRU Facts: • Equilibrium level of unemployment • Not observable • Not constant over time (affected by demographics, labor market frictions) • Currently thought to be just above 5%.

16. NAIRU Framework:In Pictures Inflation Rate • Point A: • Inflation fully expected and reflected in nominal wage growth. • Infactual= Infexpected= Inf1 • Actual unemployment rate = Natural rate of unemployment Inf1 A Unemployment Rate Un=U1

17. NAIRU FrameworkIn Pictures Inflation Rate B Inf2 • Now, central bank unexpectedly speeds up monetary growth. • Economy perks up. • Unemployment falls to U2. • Inflation rises to inf2 . Inf1 A Unemployment Rate U2 Un=U1

18. NAIRU Framework Why does unemployment fall? • Workers agreed to nominal wage contracts expecting inflation to be inf1. • Inflation rate ends up somewhat higher at inf2. • Firms increase demand for labor because actual real wage has fallen. NAIRU framework can explain short-run non-neutrality of money!

19. What happens in long run? Drop 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 (inf2). • Absent additional stimulus, unemployment rate returns to natural rate. Money still neutral in long run!

20. The NAIRU Framework:In Pictures Inflation Rate B Result: After adjustment of inflation expectations, unemployment drifts back to the natural rate (Point C), but with a new permanently higher inflation rate (inf2). Inf2 C Inf1 A Unemployment rate U2 Un=U1

21. NAIRU Framework In 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.

22. NAIRU Framework:Time-Inconsistency Angle Can’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: Inflation will be higher because central bank must accommodate the expected policy (why?), but unemployment remains at natural rate.

23. NAIRU Framework:Time-Inconsistency Angle Inflation Rate Inf2 C Result: In the end, inflation will be higher but unemployment will be no lower (point C). Inf1 A Unemployment Rate Un=U1 Policy under discretion produces results in each period inconsistent with long-run policy goals (time-inconsistency problem).

24. NAIRU Framework:Time-Inconsistency Angle Inflation Rate Result: Only binding rule, can make central bank’s commitment to price stability credible and keep inflation at point A. Inf2 C Inf1 A Unemployment rate Un=U1

25. NAIRU Framework:Time-Inconsistency Angle Note result (inflationary bias) does not depend on: • Imperfect knowledge • Imperfect monetary tools • Agency problems (differences in public’s and central bank’s objective functions).

26. Rules vs. Discretion:The Evidence 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 may lead to greater economic stability. • Many economists believe U.S. business-cycle fluctuations have been milder since World War II.

27. A Closer Look at Activist Rules:The Taylor Rule Fed funds rate target = inflation rate + equilibrium real fed funds rate+ 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

28. A Closer Look at Activist Rules:The Taylor Rule 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 = (3%) + (2%) + ½ (1%) + ½ (1%) = 6%

29. Time-Inconsistency Problem Other Solutions Besides rules… • Reputation building • Incentive-compatible contracts for central bankers • “Conservative” central bankers

30. Inflation Targeting: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:Can you really hold central bank accountable for an inflation target?

31. How does the Fed set policy? Taylor Rule and Fed Funds Rate 1960-2003 Taylor rule describes policy under Greenspan fairly well.

32. Advanced Topics in Monetary Policy: Central-Bank Independence and Rules vs. Discretion? Questions over: ? ? ? ? ? ? ? ? ? ? ? ? ? ?