The economics of money, banking, and financial institutions 2nd ch18

Chapter 18 Conduct of Monetary  Policy: Goals and  Targets © 2005 Pearson Education Canada Inc Goals of Monetary Policy Goals High Employment Economic Growth Price Stability Interest Rate Stability Financial Market Stability Foreign Exchange Market Stability Goals often in conflict © 2005 Pearson Education Canada Inc 18-2 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 self­respect, 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 18-3 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 18-4 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 18-5 Interest-Rate Stability • Interest­rate stability is desirable because fluctuations in  interest rates can create uncertainty and make it harder (for  bothfirmsandhouseholds)toplanforthefuture. Acentralbankmayalsowanttoreduceupward movementsininterestratesbecausesuchmovements generatehostilitytowardcentralbanksandleadto demandsthattheirindependenceandpowershouldbe reduced(seeChapter14) â 2005 Pearson Education Canada Inc 18-6 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 18-7 Stability in Foreign Exchange Markets E  euro $ • 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 18-8 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  intheshortrun(butprobablynotinthelongrun).For example,whentheeconomyisexpandinganduboth andimaystartto.IftheBanktriestopreventanini,this maycausetheeconomytooverheatandstimulate.Butif theBankitoprevent,intheshortrunumay Theconflictamonggoalsmaythuspresentcentralbanks withsomehardchoices! â 2005 Pearson Education Canada Inc 18-9 Central Bank Strategy © 2005 Pearson Education Canada Inc 18-10 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 uses inflation 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 18-21 Inflation Rate and Inflation Targets for Canada, 1980-2002 © 2005 Pearson Education Canada Inc 18-22 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 18-23 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 (G­5) ­­­ 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 G­5 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 18-24 Inflation Targeting Five Elements  Public announcement of medium­term ­target  Institutional commitment to price stability  Information inclusive strategy  Increased transparency through public communication  Increased accountability © 2005 Pearson Education Canada Inc 18-25 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 time­inconsistent 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 18-26 Disadvantages of Inflation Targeting Delayed signalling Too much rigidity   Potential for increased output fluctuations Low economic growth © 2005 Pearson Education Canada Inc 18-27 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 E­targeting) 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 18-28 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 18-29 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 medium­term  targets toward the long­run goal –     © 2005 Pearson Education Canada Inc 18-30 Low Economic Growth     It has also been argued that ­targeting may lead to low growth  in Y.      Although  reduction has been associated with below­normal  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 18-31 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  © 2005 Pearson Education the Bank Canada Inc 18-32 An Example of the Taylor Rule Suppose that the equilibrium real overnight rate is 2%,  that*=2%and=3%,leadingtoapositiveinflation gapofư*=1%(=3%ư2%).Alsoassumethatreal GDPis1%aboveitspotential,resultinginapositive outputgapof1%. ThentheTaylorrulesuggeststhattheovernightrate shouldbesetat ior=3%+2%+ẵ(1%inflationgap) +1/2(1%outputgap)=6% â 2005 Pearson Education Canada Inc 18-33 Taylor Rule, NAIRU and the 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