Monetary Economics Lecture 10. December 4, 2007

1. Monetary EconomicsLecture 10. December 4, 2007 Robert TCHAIDZE MONETARY ECONOMICS

2. What have we done • We concluded that using a rule is better than operating under discretion. • Poole’s analysis suggests that using interest rate as a monetary policy instrument may be preferable if money demand and/or supply are unstable. • Using a two-equation model we found that an optimal rule could be a Taylor rule. MONETARY ECONOMICS

3. Optimal Policy. Model MONETARY ECONOMICS

4. Optimal Policy. Algorithm MONETARY ECONOMICS

5. Monetary Policy Rules • Simple and transparent so that they are easy to communicate, implement, and verify. • In particular, they should be based on easily accessible data. • Robust – they should be optimal in different models. MONETARY ECONOMICS

6. Early Examples of Rules • Milton Friedman’s k-percent rule: MV = PY Δm + Δv = Δp + Δy Δm = π* + Δy* – Δv* • If velocity is stable, then money growth is equal to growth rate of nominal GDP. • Friedman suggested 4% growth of money supply believing that potential output growth is 4 percent. MONETARY ECONOMICS

7. Taylor Rules • Overview from Orphanides, 2007 and Carare and Tchaidze, 2005. • John Taylor found a rule which seemed to fit behavior of the Fed in the late 1980s and early 1990s. • Many believed that the Fed was acting optimally, hence the rule seemed to be an optimal one. • Meanwhile theoretical work suggested optimal rules that were similar to the one Taylor suggested. MONETARY ECONOMICS

8. The Taylor Rule iff =  + 2 + 0.5( – 2) + 0.5(GDP gap) where iff = nominal federal funds rate target GDP gap = 100 x (Y – Y*)/Y* = percent by which real GDP is below its natural rate MONETARY ECONOMICS

9. The Taylor Rule iff =  + 2 + 0.5( – 2) + 0.5(GDP gap) • If  = 2 and output is at its natural rate, then policy interest rate is targeted at 4 percent. • For each one percentage point increase in , monetary policy is automatically tightened to raise policy interest rate by 1.5 percentage points. • For each one percentage point that GDP falls below its natural rate, monetary policy automatically eases to reduce the policy interest rate by 0.5 percentage points. MONETARY ECONOMICS

10. Actual Taylor’s Rule The Fed policy interest rate: Actual and suggested 12 Percent 10 8 6 4 2 0 1987 1990 1993 1996 1999 2002 2005 MONETARY ECONOMICS

11. Uses of Taylor Rules • Theoretical papers: • Are simple rules optimal? • How do they perform in different macroeconomic models? • Do they solve the time inconsistency bias? • Empirical Descriptive papers • To what extent are simple instrument rules good empirical descriptions of central bank behavior? • What is the average response of an instrument variable to movements in various fundamentals? MONETARY ECONOMICS

12. Uses of Taylor Rules • Empirical Prescriptive papers • What should interest rate be? • How should interest rate be set? • Suggestions are based on the benchmark rules that are either outcome of theoretical papers or the result of estimating “good/successful” periods of monetary policy → Potential problems MONETARY ECONOMICS

13. Modifications of a Taylor Rule • Functional form • Interest rate smoothing • Unemployment gap • Growth rates of fundamentals • Allowing for policy disturbance • Timing of fundamentals • Lagged fundamentals • Leads/forecasts (within a model or exogenous) MONETARY ECONOMICS

14. Wrong Choice of a Benchmark Rule (1) Theoretical papers • Commitment to simple rules may not always be optimal (Svensson, 2003; Woodford, 2001) • Price level may not be determined, i.e. multiple equilibria (Benhabib, Schmitt-Grohe and Uribe, 2001; Carlstrom and Fuerst, 2001) • Simple policy rules may not be robust across different models (Giannoni and Woodford 2003a, 2003b; Svensson and Woodford, 2004; Walsh, 2003) • How should policy makers respond to the presence of the measurement errors? (Orphanides, 2001; Onatski and Stock, 2002; Swansson, 2000) • How do you measure inflation and output gap? • Judgmental element is being ignored MONETARY ECONOMICS

15. Wrong Choice of a Benchmark Rule (2)Empirical Descriptive papers • Is “goodness” of a historical episode indeed due to wise policy making? • Even if you found the rule, it may not be there. • Can one really impose the implied response coefficients and targets from one regime to another? • What about changes in the attitude of policy makers? • Standard errors, i.e. blurred prescriptions. • Only coefficients get remembered not variables. • Judgmental element is being ignored. • Can we actually properly estimate the rules? MONETARY ECONOMICS

16. Estimation Problems • Serial correlation. • Are the estimators robust? • Short sample. • Long sample. • Real-time data. • Rudebusch: illusion of interest rate smoothing. • Orphanides: illusion of high interest rate smoothing. MONETARY ECONOMICS

17. Illusion of Interest Rate Smoothing • Orphanides (reduced form effect): “Estimation of a policy reaction with a mis-specified horizon can yield extremely misleading information regarding the responsiveness of policy to the inflation and real economic activity outlook” • Rudebusch (high persistence effect): “A standard policy rule with slow partial adjustment and no serial correlation in the errors will be difficult to distinguish empirically from a policy rule that has immediate policy adjustment but highly serially correlated shocks” MONETARY ECONOMICS

18. Inflation Targeting • Based on Mishkin, 2004. • Target rule rather than an instrument rule. • Popular framework – New Zealand, UK, Sweden, Canada, Israel, Eurozone, …Although some people believe it is nothing particular … • Involves a formal announcement of inflation target, which is to be achieved within a certain period. • Central Bank publishes regular inflation reports that guide public. • There is an institutional commitment with price stability as a main goal and all the other goals being subordinated. MONETARY ECONOMICS

19. IT in Emerging Economies? • Calvo and Mishkin point out 5 fundamental differences between developed and emerging economies: • Weak fiscal institutions; • Weak financial institutions; • Low credibility of monetary institutions; • Currency substitution and dollarization; • Vulnerability to sudden stops. MONETARY ECONOMICS

20. Dominance of exchange rate • Weak institutions make countries vulnerable to high inflation and currency crises, hence, dollarization of deposits. • Dollarization of deposits leads to dollarization of lending (liabilities). • A sharp depreciation would raise the value of liabilities, decreasing the net worth of borrowers. • Hence, “fear of float,” that puts an extra constraint on monetary policy. MONETARY ECONOMICS

21. Dominance of exchange rate • “Sudden stops” – a sharp reversal of capital inflows, which is to a large degree unanticipated. • These could be result of external factors. For example, a liquidity crunch may force investors to drop assets of emerging economies altogether. • Implications of sudden stops are difficult to predict, but factors that make it worse are level of debt and degree of liability dollarization. MONETARY ECONOMICS

22. Homework • Chapter 8, problems 7, 8. MONETARY ECONOMICS