Monetarism & Monetary Targeting• Rules not discretion!! End monetary mischief!!!

MV = PY … automatic stabilization???M1? M2?? Innovations

Does targeting M change V???– Fed began to announce targets for money supply

growth in 1975.– Paul Volker (1979) focused on nonborrowed reserves– Greenspan (July 1993)announced the Fed would not

use any monetary aggregates to guide monetary policy

• Nominal GDP targeting??? PY– Automatic stabilization???

Inflation TargetingBernanke, Laubach, Mishkin, Posen (1999)NZ (1990), CN (1991), UK (1992), S, Su (1993)…Au,E,Is,Chile,Brazil• Announcement of medium-term numerical target for π • Institutional commitment to price stability as primary, long-run goal

of monetary policy• Information-inclusive approach in which many variables are used in

making decisions• Increased transparency of the strategy

– π understood by all … B of E Inflation Report

• Increased accountability of central bank

“Constrained discretion”• Flexible: don’t ignore things other than inflation

FIGURE 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2008

Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999), updates from the same sources, and www.rbnz.govt .nz/statistics/econind/a3/ha3.xls.

Inflation Targeting• Advantages

– Does not rely on one variable to achieve target– Easily understood– Reduces time-inconsistency risk– Stresses transparency and accountability

• Disadvantages– Delayed signaling– Too much rigidity??? – Really not– Potential for increased output fluctuations– Low economic growth during disinflation

Monetary Policy with an Implicit Nominal Anchor … The Greenspan Standard

• No explicit nominal anchor• Forward looking behavior and periodic “preemptive

strikes”– Prevent inflation from getting started.

• Bubbles and The Greenspan Put – 1987 … ok– 1998 LTCM … ok– 2000 dot.com … ok– 2007 housing bubble … ouch!!!

• Tools– Open market operation– Reserve requirements– Discount rate

• Policy instrument (operating instrument)– Reserve aggregates– Interest rates

• Interest-rate and aggregate targets are incompatible (must chose one or the other).

Targeting Nonborrowed Reserves

(a monetary aggregate)Targeting the Federal

Funds Rate

The Taylor Rule, NAIRU, and the Phillips Curve

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 gapStabilizing real output is an important concernOutput gap is an indicator of future inflation (Phillips

Curve)• NAIRU

– Rate of unemployment at which there is no tendency for inflation to change

Fed policy stance, expectations and real interest ratesireal = i – πe

Expectations hypothesis: Expected short-rates long rates

i ff target = 2% + π + .5(π – π*) + .5(Y – Yfe)

The Taylor Rule for the Federal Funds Rate 1970–2008

Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.

Central Bank Response to Asset Price Bubbles: Lessons From the Subprime Triggered Crisis

– Credit-driven bubbles• Subprime triggered financial crisis

– Bubbles driven solely by irrational exuberance• Bubbles are easier to identify when asset prices

and credit are increasing rapidly at same time. – The “Greenspan Put”

• Can’t judge when it’s a bubble and when it’s a “new era”

– Include asset prices in measure of inflation?• Raising rates to prick a bubble can damage macroeconomy• Clean up after the bubble bursts.

– Mishkin’s preference: “Macroprudential regulation”• Oppose feedbacks from credit - to asset prices - to credit• Raise credit standards … in shadow banking system too?

Historical Perspective I

• Discount policy and the real bills doctrine• Discovery of open market operations• The Great Depression• Reserve requirements as a policy tool

– Thomas Amendment to the Agricultural Adjustment Act of 1933

• War finance and the pegging of interest rates

Historical Perspective II

• Targeting money market conditions– Procyclical monetary policy

• Targeting monetary aggregates• New Fed operating procedures

– De-emphasis of federal funds rate• De-emphasis of monetary aggregates

– Borrowed reserves target• Federal funds targeting again

– Greater transparency

Historical Perspective III

• Preemptive strikes against inflation• Preemptive strikes against economic

downturns and financial disruptions– LTCM– Enron– Subprime meltdown

• International policy coordination