The Price Stability Goal
Low and stable inflation
Inflation
Creates uncertainty and difficulty in planning for future
Lowers economic growth
Strains social fabric
Nominal anchor
Time-inconsistency problem
Other Goals of Monetary Policy
High employment
Economic growth
Stability of financial markets
Interest-rate stability
Foreign exchange market stability
Should Price Stability be the 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 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 I
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 II
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 during disinflation
Monetary policy is the monitoring and control of money supply by a central bank, such
as the Federal Reserve Board in the United States of America, and the Bangko Sentral ng
Pilipinas in the Philippines. This is used by the government to be able to control
inflation, and stabilize currency.
Monetary Policy is considered to be one of the two ways that the government can
influence the economy – the other one being Fiscal Policy (which makes use of
government spending, and taxes). Monetary Policy is generally the process by which the
central bank, or government controls the supply and availability of money, the cost of
money, and the rate of interest.
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…
Inflation
is the increase in the prices of goods and services over time. It's an economics term that means
you have to spend more to fill your gas tank, buy a gallon of milk, or get a
haircut. Inflation increases your cost of living. Inflation reduces the purchasing power of each
unit of currency.
Nominal anchors
A nominal anchor for monetary policy is a single variable or device which the central bank uses
to pin down expectations of private agents about the nominal price level or its path or about
what the central bank might do with respect to achieving that path. Nominal variables used as
anchors primarily include exchange rate targets, money supply targets, and inflation targets
with interest rate policy
Time-inconsistency
the effect of the time-inconsistency is called stabilization bias because the time-
inconsistency affects the central banker's ability to stabilize inflation expectations and hence
stabilize inflation itself.
High Employment
High unemployment creates both personal and societal costs
With unemployment, there are idle resources that could be put to work.
Tricky policy target, as the natural rate can change over time.
Better short run target than a long run one.
Economic Growth
Promoting economic growth should lead to lower unemployment and lower inflation in
the long run
Supply Side Economics:
Give firms a greater incentive to invest and people a greater incentive to save.
Increased investment rates will expand the capital stock in the future.
Greater production will lead to both lower unemployment and lower prices as returns
trickle down throughout the economy
Effective in theory, but may generate significant short-run pain.
Stability Financial Market Stability Interest Rate Stability
Bank panics and financial crises can create great strain on the economy
The Fed can help avert these crises by acting as a lender of last resort and providing
technical assistance to financial markets.
Interest Rate Stability
Volatile interest rates increase uncertainty and reduce both savings and investment.
Rapidly rising interest rates may create hostility toward the Central Bank, leading to a
loss of independence.
Exchange Rate Stability
International trade and investment is damaged by wildly fluctuating exchange rates.
Central bank intervention in foreign exchange markets can temper these movements,
increasing stability.
Should Price Stability be the Primary Goal?
In the long run, price stability and the other goals of monetary policy are not mutually
exclusive.
The natural rate of unemployment is unaffected by inflation
Economic growth is only affected by real variables in the long run
Price stability will promote interest rate and exchange rate stability in the long run.
However, short-run price stability will frequently conflict with these other goals of
monetary policy.
Faced with rapidly rising prices, the Fed would have to cut the money supply and raise
interest rates
Doing so increases short-run unemployment and creates volatility in financial markets
though
Hierarchical vs. Dual Mandates
Price stability is an important goal for monetary policy, but should it take precedence
over all others?
In a hierarchical mandate, price stability is the first goal and any other policy objective may
only be targeted so long as it doesn’t interfere with price stability.
The ECB has a hierarchical mandate – it can pursue high levels of employment and economic
growth as long as it doesn’t endanger price stability.
In a dual mandate, the central bank can simultaneously pursue both price stability and other
goals (usually low unemployment). These goals may conflict in the short run.
A hierarchical mandate reinforces the public’s belief in the central bank’s commitment
to price stability.
It gets around the time inconsistency problem by limiting the policies that the central
bank can do.
However, it can lead to the central bank targeting short-run price stability, leading to
large fluctuations in output and employment.
A dual mandate gives central banks the freedom to stabilize employment in the short
run while still setting a long run policy target of price stability.
However, the dual mandate is subject to the time inconsistency problem.
If people believe that the central bank is always going to promote employment over
price stability in the short run, they will revise their inflation expectations upward.
Monetary Targeting
To achieve price stability, you need to have some benchmark that tells you how stable
prices are.
Two such targets are widely used: monetary aggregates and the inflation rate.
In monetary targeting, the central bank announces that it will target an annual growth rate in a
particular monetary aggregate (like M1 or M2).
Once the rate is set, the Central Bank is responsible for hitting this target
This policy is transparent, flexible and accountable.
It sends a strong signal of the Central Bank’s policy objective and inflation expectations
should adjust.
However, it does require that the target (M1 for example) and the goal variable
(inflation) have a strong relationship.
Inflation Targeting
The biggest weakness of monetary targeting is that there may not be a strong
relationship between the monetary target and inflation.
So why not directly target inflation?
With inflation target, the central bank makes a public announcement of the inflation
target.
This is an attempt to revise inflation expectations
Then the central bank makes an institutional commitment to price stability (and the
inflation target) as a long-run goal.
Policy decisions (to hit the inflation target) are made using as much information as is
available
The process by which the central bank reached a policy is made transparent through
open communication with the public
If the central bank fails to hit its objective, it is held accountable.
Inflation Targeting
Inflation targeting has been successfully used to achieve long-run price stability in
Canada, New Zealand, and the UK.
However, the process by which long-run stability was achieve involved significant short-
term pain.
Advantages
1. Does not rely on one variable to achieve the target
2. Transparent and policymakers are accountable for their actions.
3. Better insulated from time-inconsistency problem.
Disadvantages
1. Delayed signaling inflation rates are known ex-post, oftentimes with long lags. Need to
know current rate to know the stance of the central bank’s target.
2. Too inflexible, potentially leading to disruptive output fluctuations
3. During the transition period, there is low economic growth how long until we reach
the long run?
