2008 Pearson Education Canada18.1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals,...

© 2008 Pearson Education Canada18.1

Chapter 18Chapter 18What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics


The Price Stability GoalThe Price Stability Goal• Low and stable inflation• Inflation

– Creates uncertainty and difficulty in planning for future

– Lowers economic growth– Strains social fabric

• Nominal anchor ignore

• Time-inconsistency problem ignore


Other Goals of Monetary PolicyOther Goals of Monetary Policy

• High employment• Economic growth• Stability of financial markets• Interest-rate stability• Foreign exchange market stability


Should Price Stability be the Should Price Stability be the Primary Goal?Primary Goal?

• In the long run there is no conflict between the goals

• In the short run it can conflict with the goals of high employment and interest-rate stability

• Hierarchical mandate• Dual mandate


Monetary TargetingMonetary Targeting• Flexible, transparent, accountable• Advantages

– Almost immediate signals help fix inflation expectations and produce less inflation

– Almost immediate accountability

• Disadvantages– Must be a strong and reliable relationship between the

goal variable and the targeted monetary aggregate


Inflation Targeting Inflation Targeting • 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


Inflation Targeting In Inflation Targeting In Canada Canada

• In 1991, the minister of finance and the governor of the Bank of Canada established formal inflation targets

• The target range was 2-4% by the end of 1992, 1.5-3% by June 1994 and 1-3% by December 1996


• After a new government took office in 1993, the target was set at 1-3% and has been kept at this level ever since

• Canadian inflation has fallen dramatically since the adoption of targets, falling from 5% in 1991, to zero in 1995 and between 1-2% in the late 1990’s


Inflation TargetingInflation Targeting


Inflation Targeting Inflation Targeting (Cont’d)(Cont’d)

• Advantages– Does not rely on one variable to achieve

target– Easily understood– Reduces potential of falling in

time-inconsistency trap– Stresses transparency and accountability


• Disadvantages– Delayed signaling– Too much rigidity– Potential for increased output fluctuations– Low economic growth


Implicit Nominal AnchorImplicit Nominal Anchor• Brief discussion

• Forward looking and preemptive• Advantages

– Uses many sources of information– Avoids time-inconsistency problem– Demonstrated success


• Disadvantages– Lack of transparency and accountability– Strong dependence on the preferences, skills,

and trustworthiness of individuals in charge– Inconsistent with democratic principles


Advantage and Disadvantages of Advantage and Disadvantages of Different Monetary StrategiesDifferent Monetary Strategies


Tactics: Tactics: Choosing the Policy InstrumentChoosing the Policy Instrument

• Tools– Open market operation– Government deposit shifting– Last resort lending– Overnight interest rate


• Policy instrument (operating instrument)– Reserve aggregates– Interest rates– May be linked to an intermediate target

• Interest-rate and aggregate targets are incompatible


Result of Targeting Non-Result of Targeting Non-borrowed Reservesborrowed Reserves

• Brief


Result of Targeting Non-Result of Targeting Non-borrowed Reservesborrowed Reserves


Result of Targeting Overnight Result of Targeting Overnight FundsFunds


The Taylor Rule, NAIRU, The Taylor Rule, NAIRU, and the Phillips Curve and the Phillips Curve (brief)(brief)

Overnight interest rate = inflation rate + equilibrium overnight rate + ½ (inflation gap) + ½ (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– Rate of unemployment at which there is no

tendency for inflation to change

2008 Pearson Education Canada18.1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals,...

Documents

Transcript of 2008 Pearson Education Canada18.1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals,...