The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Chapter 17
The Conduct of Monetary
Policy: Strategy and Tactics

Copyright © 2019 Pearson Education, Ltd.

The Price Stability Goal and the Nominal
Anchor
• Over the past few decades, policy makers 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.
• The role 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
• The time-inconsistency problem

Copyright © 2019 Pearson Education, Ltd.

Other Goals of Monetary Policy
• Five other goals are continually mentioned by central bank
officials when they discuss the objectives of monetary
policy:
1. High employment and output stability
• To achieve the level of full employment, which is
called the natural rate of unemployment
2. Economic growth
3. Stability of financial markets
4. Interest-rate stability
• Fluctuations in interest rates create uncertainty for
financial institutions
5. Stability in foreign exchange markets
Copyright © 2019 Pearson Education, Ltd.
Should Price Stability Be the Primary Goal
of Monetary Policy?
• Hierarchical versus Dual Mandates:
– Hierarchical mandates put the goal of price stability first,
and then say that as long as it is achieved other goals can
be pursued
– Dual mandates are aimed to achieve two equally important
objectives: price stability and maximum employment (output
stability)
• Price Stability as the Primary, Long-Run Goal of Monetary Policy
– Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the long
run but not the short run. Attempts to keep inflation at the
same level in the short run will cause excessive output
fluctuations.
Copyright © 2019 Pearson Education, Ltd.
Inflation Targeting (1 of 3)
Inflation targeting involves several elements:
• Public announcement of medium-term numerical target for
inflation
• Institutional commitment to price stability as the primary,
long-run goal of monetary policy and a commitment to
achieve the inflation goal
• Information-inclusive approach in which many variables
are used in making decisions
• Increased transparency of the strategy
• Increased accountability of the central bank
Copyright © 2019 Pearson Education, Ltd.
Inflation Targeting (2 of 3)
• New Zealand (effective in 1990)
– Inflation was brought down and remained within the
target most of the time.
– Growth has generally been high, and unemployment
has come down significantly.
• Canada (1991)
– Inflation decreased since 1991; some costs in term of
unemployment
• United Kingdom (1992)
– Inflation has been close to its target.
– Growth has been strong, and unemployment has been
decreasing.
Copyright © 2019 Pearson Education, Ltd.
Inflation Targeting (3 of 3)
• Advantages:
– Reduction of the time-inconsistency problem
– Increased transparency
– Increased accountability
– Consistency with democratic principles
– Improved performance
• Disadvantages:
– Delayed signaling
– Too much rigidity
– Potential for increased output fluctuations
– Low economic growth during disinflation
Copyright © 2019 Pearson Education, Ltd.
The Evolution of the Federal Reserve’s
Monetary Policy Strategy (1 of 2)
• The United States has achieved excellent macroeconomic
performance (including low and stable inflation) until the
onset of the global financial crisis without using an explicit
nominal anchor such as an inflation target.

Copyright © 2019 Pearson Education, Ltd.

The Evolution of the Federal Reserve’s
Monetary Policy Strategy (2 of 2)
• There is no explicit nominal anchor in the form of an
overriding concern for the Fed.
• Forward looking behavior and periodic “preemptive strikes”
• The goal is to prevent inflation from getting started.
• Advantages
– Uses many sources of information
– Demonstrated success
• Disadvantages
– Lack of accountability (there is no predetermined
criteria for judging its performance)
– Inconsistent with democratic principles
Copyright © 2019 Pearson Education, Ltd.
The Fed’s “Just Do It” Monetary Policy
Strategy (1 of 2)
• Fed’s policy regime prior to the global financial crisis might
best be described as a “just do it” policy

Copyright © 2019 Pearson Education, Ltd.

The Fed’s “Just Do It” Monetary Policy
Strategy (2 of 2)
• Advantages of the Fed’s “Just Do It” Approach:
– forward-looking behavior and stress on price stability
also help to discourage overly expansionary monetary
policy, thereby ameliorating the time-inconsistency
problem
• Disadvantages of the Fed’s “Just Do It” Approach:
– lack of transparency (for the lack of an explicit nominal
anchor); strong dependence on the preferences, skills,
and trustworthiness of the individuals in charge of the
central bank

Copyright © 2019 Pearson Education, Ltd.

Inside the Fed: Ben Bernanke’s Advocacy of
Inflation Targeting
• While a professor at Princeton, Bernanke, in several
articles and in a book cowritten with the author of this
book, argued that inflation targeting would be a major step
forward for the Federal Reserve and would produce better
economic outcomes, for many of the reasons outlined
earlier. When Bernanke took his position as a governor of
the Federal Reserve from 2002 to 2005, he continued to
advocate the adoption of an inflation target.

Copyright © 2019 Pearson Education, Ltd.

Global: The European Central Bank’s
Monetary Policy Strategy
• The European Central Bank (ECB) has also been slow to
move toward inflation targeting, adopting a hybrid
monetary strategy that includes some elements of inflation
targeting.

Copyright © 2019 Pearson Education, Ltd.

Lessons for Monetary Policy Strategy from
the Global Financial Crisis
1. Developments in the financial sector have a far greater
impact on economic activity than was earlier realized.
2. The zero-lower-bound on interest rates can be a serious
problem.
3. The cost of cleaning up after a financial crisis is very
high.
4. Price and output stability do not ensure financial stability.

Copyright © 2019 Pearson Education, Ltd.

Should Central Banks Respond to
Bubbles? (1 of 2)
• How should Central banks respond to asset price bubbles?
– Asset-price bubble: pronounced increase in asset
prices that depart from fundamental values, which
eventually burst.
• Types of asset-price bubbles
– Credit-driven bubbles
 Housing price bubble
– Bubbles driven solely by overly optimistic
expectations, dubbed by “irrational exuberance”

Copyright © 2019 Pearson Education, Ltd.

Should Central Banks Respond to
Bubbles? (2 of 2)
• Strong argument for not responding to bubbles driven by
irrational exuberance.
• Bubbles are easier to identify when asset prices and credit
are increasing rapidly at the same time.
• Monetary policy should not be used to prick bubbles.

Copyright © 2019 Pearson Education, Ltd.

Should Central Banks Respond to Bubbles?
• Macropudential policy: regulatory policy to affect what is
happening in credit markets in the aggregate (e.g.,
adequate disclosure and capital requirement, prompt
corrective actions, close monitoring of financial institutions’
risk management procedures).

• Monetary policy: low interest rate policies were followed

by excessive risk-taking, suggesting that overly easy
monetary policy causes financial instability. This channel
also suggests that monetary policy should be used to lean
against credit booms

Copyright © 2019 Pearson Education, Ltd.

Tactics: Choosing the Policy Instrument
• Tools
– Open market operation
– Reserve requirements
– Discount rate
• Policy instrument (operating instrument)
– Reserve aggregates
– Interest rates
– May be linked to an intermediate target

Copyright © 2019 Pearson Education, Ltd.

Figure 2 Linkages Between Central Bank Tools,
Policy Instruments, Intermediate Targets, and Goals
of Monetary Policy

Copyright © 2019 Pearson Education, Ltd.

Criteria for Choosing the Policy Instrument
• Observability and Measurability
• Controllability
• Predictable effect on Goals

Copyright © 2019 Pearson Education, Ltd.

Tactics: The Taylor Rule
Federal funds rate target =
inflation rate  equilibrium real fed funds rate
1/2 (inflation gap)  1/2 (output gap)
• An inflation gap and an output gap
– Stabilizing real output is an important concern
– Output gap is an indicator of future inflation as shown
by Phillips curve
• NAIRU (nonaccelerating inflation rate of unemployment)
– Rate of unemployment at which there is no tendency
for inflation to change
Copyright © 2019 Pearson Education, Ltd.
Figure 5 The Taylor Rule for the Federal
Funds Rate, 1960–2017

Source: Calculations with Federal Reserve Bank of St. Louis FRED database:
https://fred.stlouisfed.org/series/PCECTPI; https://fred.stlouisfed.org/series/GDPC1;
https://fred.stlouisfed.org/series/GDPPOT; https://fred.stlouisfed.org/series/DFFGDPC1.

Copyright © 2019 Pearson Education, Ltd.

Inside the Fed: The Fed’s Use of the Taylor
Rule
• Putting monetary policy on autopilot by using a Taylor rule
with fixed coefficients is problematic. The Taylor rule is
useful, however, as a guide to monetary policy.

Copyright © 2019 Pearson Education, Ltd.