Chapter 18

1. Chapter 18 Conduct of Monetary Policy: Goals and Targets © 2005 Pearson Education Canada Inc.

2. Goals of Monetary Policy Goals 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict © 2005 Pearson Education Canada Inc.

3. High Employment High employment is a worthy goal for two reasons: 1. The alternative situation, high unemployment, causes much human misery, with people suffering financial distress, loss of personal self-respect, and  in crime. 2. When u is high, the economy has not only idle workers but also idle resources, resulting in a lower GDP. But how low should u be? Because frictional unemployment (which involves searches by workers and firms to find suitable matchups) is desirable, and because policy can do little about structural unemployment (due to a mismatch between job requirements and the skills of workers), the goal of high employment should seek not u = 0 but u > 0 consistent with full employment (at which the demand for labor equals the supply of labor). This level of u is called the natural rate of unemployment. © 2005 Pearson Education Canada Inc.

4. Economic Growth The goal of steady economic growth is closely related to the goal of low u because businesses are more likely to invest in physical capital to  productivity and growth when u is low. If u is high and factories are idle, it does not pay for firms to invest in additional physical capital. Hence, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. In fact, this is the stated purpose of so-called supply-side economic policies, which provide tax incentives for firms to invest more and for people to save more. © 2005 Pearson Education Canada Inc.

5. Price Stability • In recent years policymakers have become increasingly aware of the social and economic costs of inflation and more concerned with a stable P as a goal of economic policy. • In fact, P stability is viewed as the most important goal for monetary policy because • inflation creates uncertainty that may hamper growth • inflation makes it hard to plan for the future • inflation may strain a country’s social fabric (by creating conflicts between different groups) • extreme inflation, known as hyperinflation, leads to slower growth as for example in Argentina, Brazil, and Russia in the recent past. © 2005 Pearson Education Canada Inc.

6. Interest-Rate Stability • Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty and make it harder (for both firms and households) to plan for the future. • A central bank may also want to reduce upward movements in interest rates because such movements generate hostility toward central banks and lead to demands that their independence and power should be reduced (see Chapter 14). © 2005 Pearson Education Canada Inc.

7. Stability of Financial Markets • Financial crises can interfere with the ability of financial markets to channel funds from surplus spending units to deficit spending units, thereby leading 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. • The stability of financial markets is also fostered by i stability because fluctuations in i create uncertainty for financial firms, affecting both their profits as well as their net worth. © 2005 Pearson Education Canada Inc.

8. Stability in Foreign Exchange Markets • The value of the $ has become a major consideration for the Bank of Canada. An  in E makes Canadian industries less competitive with those abroad and a  in E stimulates inflation in Canada. • Also preventing large changes in E makes it easier for firms and people involved in international trade to plan ahead. • Stabilizing extreme movements in E in FX markets is thus viewed as a worthy goal of monetary policy. In fact, in countries which are even more dependent on foreign trade, stability in FX markets takes on even greater importance. © 2005 Pearson Education Canada Inc.

9. Conflict Among Goals • Many of the goals mentioned are consistent with each other as, for example, • high employment with economic growth, and • i stability with financial market stability. • However, P stability is in conflict with i stability and low u in the short run (but probably not in the long run). For example, when the economy is expanding and u both  and i may start to . If the Bank tries to prevent an  in i, this may cause the economy to overheat and stimulate . But if the Bank  i to prevent , in the short run u may . • The conflict among goals may thus present central banks with some hard choices! © 2005 Pearson Education Canada Inc.

10. Central Bank Strategy © 2005 Pearson Education Canada Inc.

11. Use of (Operating and Intermediate) Targets • Suppose that the Bank wants to achieve a 5% rate of growth for nominal GDP and is targeting an aggregate (say M1+). If the Bank feels that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M1+ (its intermediate target), which will in turn be achieved by a 3% MB growth rate (its operating target), it will use its tools to achieve the 3% MB growth rate. • After implementing this policy, if the Bank finds that MB is growing too slowly, it can use open market purchases to increase it. Somewhat later the Bank will begin to see how its policy affects the growth rate of M1+. If M1+ is growing too fast (say at 7%), the Bank will reduce its open market purchases or make open market sales to reduce the M1+ growth rate. © 2005 Pearson Education Canada Inc.

12. 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i'' Money Supply Target © 2005 Pearson Education Canada Inc.

13. 1. M dfluctuates between M d' and M d'' 2. To set i-target at i* Ms fluctuates between M' and M'' Interest Rate Target © 2005 Pearson Education Canada Inc.

14. Choosing Targets The conclusion from Figures 18-2 and 18-3 is that interest rate and monetary aggregate targets are incompatible: a central bank can hit one or the other but not both. Because a choice between them has to be made, we need to examine what criteria should be used to decide on the target variable. © 2005 Pearson Education Canada Inc.

15. Criteria for Choosing Targets Criteria for Intermediate Targets 1. Measurability 2. Controllability 3. Ability to Predictably Affect Goals Interest rates aren’t clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates Criteria for Operating Targets Same criteria as above Reserve aggregates and interest rates about equal on criteria 1 and 2. For 3, if intermediate target is M s, then reserve aggregate is better © 2005 Pearson Education Canada Inc.

16. History of Bank of Canada Policy Procedures Early Years: Interest Rate Targeting 1962-1971, Fixed exchange rate (Bretton Woods System) 1971-1975, Flexible exchange rate Result:During the early years, i or (i - i*) were the intermediate target of Canadian monetary policy and the Bank’s objective was to keep the FX market and domestic bond markets functioning smoothly. The Bank paid no attention to the growth rate of M. As a result, monetary policy was expansionary and by 1974  to double digits (to 11%) compared to only 3% in 1971. © 2005 Pearson Education Canada Inc.

17. Inflation Rates During the early years, i or (i - i*) were the intermediate target of Canadian monetary policy. As a result, i and  followed generally similar patterns in Canada and the U.S. Interest Rates © 2005 Pearson Education Canada Inc.

18. Targeting Monetary Aggregates: 1975-81 By the end of 1975 there was a consensus among central banks that fluctuations in M contained useful information about P and Y. This evidence contributed to the rise of monetarism (a theory that emphasized a steady, predictable ). In response to this and the rising  in the early 1970’s, the Bank introduced a program of “monetary gradualism,” under which M1 growth would be controlled within a gradually falling target range (see Table 18-1). The Bank, however, continued to use an interest rate as its operating target Result:Bank was successful at keeping actual M1 growth within the target range (see Table 18-1), but   because of a series of financial innovations that  the demand for M1 and  the demand for M2. Monetary targeting was abandoned in November 1982. © 2005 Pearson Education Canada Inc.

19. The Bank was to announce in advance (in order to influence people’s  expectations) the target path for the growth of M1 and then adjust policy during the course of the year to make the actual growth rate lie within the target range. © 2005 Pearson Education Canada Inc.

20. The Checklist Approach: 1982-88 With the abandonment of M1 targets, the Bank focused on a list of factors, including i, E, and broad monetary aggregates (like M2 and M2+), but no aggregate was found suitable as a guide for conducting monetary policy. The goal of monetary policy was  containment in the short term and price stability in the long term i was the operating target and E was the intermediate target (with the Bank resisting  in E, fearing that depreciation would worsen ) Result:  again (because of a persistent federal budget deficit that made it difficult for the Bank to control M and ). The Bank responded by announcing early in 1988 that short-term issues would henceforth less guide policy and that P stability would be the Bank's long-term objective of monetary policy © 2005 Pearson Education Canada Inc.

21. Inflation Targeting: 1989-Present • In February 1991, the Bank and the minister of finance “jointly” announced explicit targets for , with a band of ±1% around them. • The targets were 3% by the end of 1992, falling to 2% by the end of 1995, to remain within a range of 1 to 3% thereafter. The 1% to 3% target range for  was renewed in 1995, in early 1998, and again in May 2001, to apply until the end of 2006 • The midpoint of the current  target range, 2%, is regarded as the most desirable outcome • In setting its  targets, the Bank usesinflation in "core CPI" which excludes volatile components (such as food, energy, and the effect of indirect taxes) • Defining the  targets in terms of ranges gives the Bank sufficient flexibility to deal with supply shocks © 2005 Pearson Education Canada Inc.

22. Inflation Rate and Inflation Targets for Canada, 1980-2002 © 2005 Pearson Education Canada Inc.

23. International Considerations • Globalization (the growing integration and interdependence of national economies) has also affected Bank of Canada policymaking in recent years. • Globalization requires international policy cooperation, to improve the functioning of international financial markets and the efficiency of domestic monetary policy. • International cooperation has been encouraged by the process of international policy coordination (agreements among countries to enact policies cooperatively) that led to the Plaza Agreement in 1985 and the Louvre Accord in 1987. © 2005 Pearson Education Canada Inc.

24. The Plaza Agreement and the Louvre Accord • The Plaza Agreement was reached at New York’s Plaza Hotel in September of 1985 between finance ministers and the heads of central banks from the Group of Five (G-5) --- the U.S., the U.K., France, West Germany, and Japan. It was agreed to bring down the value of the U.S. $ to address U.S. concerns that the strong U.S. $ was reducing the competitiveness of American corporations. • By 1987 the U.S. $ had indeed  by about 35% relative to other currencies. At this point to address concerns over the significant  in the U.S. $, policymakers from the G-5 plus Canada met in February 1987 at the Louvre Museum in Paris and agreed to stabilize exchange rates around the then prevailing levels. © 2005 Pearson Education Canada Inc.

25. Inflation Targeting Five Elements Public announcement of medium-term -target Institutional commitment to price stability Information inclusive strategy Increased transparency through public communication Increased accountability © 2005 Pearson Education Canada Inc.

26. Advantages of Inflation Targeting Allows focus on domestic considerations and enables monetary policy to respond to shocks to the domestic economy Not dependent on reliable relationship between M and  Readily understood by the public Reduce political pressures for time-inconsistent policymaking Puts great stress on making policy transparent and on regular communication with the public Increased accountability of central bank (that can be instrumental in building public support for the central bank’s independence Performance good:  and e , and stays low in business cycle upturn © 2005 Pearson Education Canada Inc.

27. Disadvantages of Inflation Targeting Delayed signalling Too much rigidity Potential for increased output fluctuations Low economic growth © 2005 Pearson Education Canada Inc.

28. Delayed Signalling Given that the Bank cannot easily control  and also the “long and variable lags” in the effects of policy,  outcomes are revealed only after a lag. Thus, an  target sends delayed signals to the markets about the stance of monetary policy. However, the signals provided by other strategies (i.e., M-targeting and E-targeting) are not very strong either. Hence, a case can be made that other strategies are not superior to inflation targeting on these grounds. © 2005 Pearson Education Canada Inc.

29. Too Much Rigidity It has been argued that -targeting imposes a rigid rule on monetary policymakers, limiting their discretion to respond to unforseen shocks. Although there are advantages from “rule like” policymaking, -targeting as practiced by the Bank of Canada is far from rigid. The Bank does not follow simple and mechanical policy rules in conducting monetary policy. In fact, it uses all available information on a number of variables to determine what policy actions are appropriate to achieve the inflation target. © 2005 Pearson Education Canada Inc.

30. Increased Output Fluctuations It has been argued that -targeting may lead to tight policy when  > * and thus may lead to larger Y fluctuations. But -targeting does not require a sole focus on . The decision of central banks to choose  targets above zero reflects the concern that zero  may have negative effects on the economy. For example, deflation is fearful (because it may promote financial instability) and targeting  > 0 makes period of deflation less likely. This is why, * = 2%. Moreover, -targeting does not ignore traditional stabilization goals. The Bank of Canada and all -targeting central banks continue to express their concern about fluctuations in Y and u. Also, they have been willing to minimize Y declines by gradually lowering medium-term  targets toward the long-run goal. © 2005 Pearson Education Canada Inc.

31. Low Economic Growth It has also been argued that -targeting may lead to low growth in Y. Although  reduction has been associated with below-normal Y during the disinflationary phases, once low  has been achieved, Y and employment return to levels as high as they were before. Hence, once low  is achieved, -targeting is not harmful to the economy, but promotes real economic growth. © 2005 Pearson Education Canada Inc.

32. The Taylor Rule How the target ior is chosen? Overnight rate = inflation + equilibrium real overnight rate + 1/2 (inflation gap) + 1/2 (output gap) The presence of both an inflation gap and an output gap in the Taylor rule indicates that the Bank cares not only about keeping  low but also about minimizing business cycle fluctuations of y around its potential. This is consistent with many statements of Bank officials that controlling  and stabilizing y are important concerns of the Bank. © 2005 Pearson Education Canada Inc.

33. An Example of the Taylor Rule Suppose that the equilibrium real overnight rate is 2%, that * = 2% and  = 3%, leading to a positive inflation gap of  - * = 1% (= 3% - 2%). Also assume that real GDP is 1% above its potential, resulting in a positive output gap of 1%. Then the Taylor rule suggests that the overnight rate should be set at ior= 3% + 2% + ½ (1% inflation gap) +1/2 (1% output gap) = 6%. © 2005 Pearson Education Canada Inc.

34. Taylor Rule, NAIRU andthe Phillips Curve An alternative interpretation of the presence of the output gap in the Taylor rule is that the output gap is an indicator of future , as stipulated in Phillips curve theory. This theory indicates that changes in  are influenced by the state of the economy relative to its productive capacity, measured by potential GDP which is a function of the natural rate of unemployment. A related concept is the NAIRU, the nonaccelerating inflation rate of unemployment (the u at which  = 0). When u > NAIRU, with GDP < potential GDP,  will  When u < NAIRU, with GDP > potential GDP,  will  Prior to 1995, NAIRU was thought to be 8%, but the  in u in the late 1990s, with no  in  has rendered Phillips curve theory highly controversial. © 2005 Pearson Education Canada Inc.

35. Taylor Rule and Overnight Rate © 2005 Pearson Education Canada Inc.