Economics 100B: Macroeconomics
Monetary Policy IV: Issues and Extensions March 10, 2022
R.J. Hawkins (2020) – A Monetary Policy Model. On bCourses as
MonetaryPolicyModelNotes-v7.pdf.
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Mishkin – Chapter 13 for discussion of issues, not the model.
J. B. Taylor, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 39, 195–214 (1993). [not required].
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Macroeconomic Policy
Issues in Macroeconomic Policy Implementation. Inflation: A Monetary Phenomenon.
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Contractionary and Expansionary Monetary Policy
Given the optimal rate rule:
12 13 14 15 16 17 18 19 20
we can compare the optimal rate to the actual rate ractual to determine whether monetary policy is contractionary or expansionary.
ractual < rt ractual > rt
expansionary contractionary
Although ractual was relatively constant in Saudi Arabia, unless r∗ and/or πT changed, the type of policy changed a lot.
Always remember that not changing the policy rate is a policy action.
Source: FRED / SAMA
TIME (year)
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RATE (%/year)
How Active Should Policy Be?
The “activist” vs. “non-activist” dichotomy:
Most macroeconomists, policymakers, and politicians have similar policy objectives:
1 High employment / low unemployment, and
2 Low and stable inflation.
However, there is a lot of disagreement, and controversy, about the
best policy to achieve these objectives.
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How Active Should Policy Be?
The “activist” vs. “non-activist” dichotomy:
Non-activists believe that wages and prices are very flexible, even in the short-run, so that the economy’s self-correcting mechanism is very rapid.
Therefore, government activity to reduce high unemployment when it develops is unnecessary.
Most economists adhering to the classical school of thought would espouse this point of view.
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How Active Should Policy Be?
The “activist” vs. “non-activist” dichotomy:
Activists believe that wages and prices are very sticky so that the economy’s self-correcting mechanism can be very slow.
Therefore, government activity to reduce high unemployment when it develops is justified.
Most economists adhering to the Keynesian school of thought would espouse this point of view.
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How Active Should Policy Be?
The “activist” vs. “non-activist” dichotomy:
In general, neither monetary nor fiscal policy can respond immediately to aggregate demand and aggregate supply shocks because of:
1 the data lag,
2 the recognition lag,
3 the legislative lag,
4 the implementation lag, and
5 the effectiveness lag.
Lecture 15 – Monetary Policy IV: R. J. 100B: Macroeconomics
How Active Should Policy Be?
The “activist” vs. “non-activist” dichotomy:
These lags make policymaking much more difficult. Some say that this weakens the case for activism.
If the policy lags are very long, then policy may become pro-cyclical rather than counter-cyclical.
This is why measurement is so important!
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“… always and everywhere a monetary phenomenon.” – Friedman, in the context of the quantity theory of money, once quipped that “inflation was always and everywhere a monetary phenomenon.”
This is consistent with our monetary-policy mode in which a central bank can target any inflation rate.
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“… always and everywhere a monetary phenomenon.” – the central bank can determine the inflation rate in the long-run, it cannot determine either:
1 Potential economic output, Y P , or
2 The equilibrium real interest rate, r∗.
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Causes of inflationary and monetary policy:
If central banks can target any inflation rate in the long-run, why are their periods of time when inflation is unacceptably high?
Generally because the government has pursued a high employment goal.
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Causes of inflationary and monetary policy:
Two types of inflation can result from policies designed to promote high employment.
Cost-push inflation results from temporary negative supply shocks, including wage increases beyond what productivity gains would justify.
Demand-pull inflation results from aggregate demand policies that attempt to maintain economic output above potential output.
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Cost-Push inflation
The economy is initially in general equilibrium with inflation at its target rate.
But now there is a negative short-run aggregate supply shock while the government is committed to maintaining a high level of employment.
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Cost-Push inflation
In the long-run:
Economic output is at its potential level.
The unemployment rate is at the natural rate. The real interest rate is at its equilibrium level. Inflation is permanently higher.
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Demand-Pull inflation
The economy is initially in general equilibrium with inflation at its target rate.
But now the government wants to increase employment to an even higher level.
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Demand-Pull inflation
In the long-run:
Economic output is at its potential level.
The unemployment rate is it the natural rate. The real interest rate is at its equilibrium level. Inflation is permanently higher.
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Cost-Push and Demand-Pull inflation: 1965–1982. After Mishkin, Figure 13.13.
15 12 9 6 3 0
01/60 01/70
Source: FRED / BLS & CBO DATE (year)
Unemployment
CPI inflation
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The Original (Taylor, 1993)
Taylor’s approach to monetary policy rule development:
A number of policy rules were considered.
Economic performance was examined under different policy rules.
Policy rules were ranked according to their success.
Econ 100B: Macroeconomics
Lecture 15 – Monetary Policy IV: R. J.
The Original (Taylor, 1993)
The original form of the Taylor rule is:
1 1 Y − Y
i = π + 2 (π − 2) + 2 Y × 100% + 2
i ≡ the nominal federal funds rate.
π ≡ the inflation rate over the past four quarters.
Y ≡ real GDP.
Y ≡ trend real GDP
We would write this as
i=i∗+1π−πT+1y−yP . 22
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The And Our Macro Model
Our monetary-policy rule
rt=r+ 1πt−π ζy γ+γβ
differs somewhat from the Taylor rule
rt = r∗ + 1 πt − πT + 1 yt − yP .
To get this form, we consider the slightly different Phillips curve: πt =πt−1+γyt−1−yP
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The And Our Macro Model
With this new Phillips curve, the loss function changes to
P2 T2 L= yt−y +β πt+1−π
which embodies the idea that a rate set today affects inflation 2 periods in the future:
rt−1 −→ yt −→ πt+1
The dynamic IS curve does not change:
yt − yP = −ζy (rt−1 − r∗) .
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The And Our Macro Model
Given the new Phillips curve, we proceed as before. Minimizing
P2 T2 L= yt−y +β πt+1−π
with respect to yt:
∂L =0=2yt−yP+2βπt+1−πT∂πt+1
0=yt −yP+γβπt+1 −πT gives us the slightly different optimal path
yt −yP=−γβπt+1 −πT
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The And Our Macro Model
Clearing inflation with the Phillips curve yt −yP=−γβπt+1 −πT
πt+1: Phillips curve
yt −yP=−γβπt +γyt −yP−πT
πt: Phillips curve
yt −yP=−γβπt−1 +γyt−1 −yP+γyt −yP−πT
we find that
1P T P − γ+γβ yt−y = πt−1−π +γ yt−1−y
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The And Our Macro Model
And, as before, we can convert this
1P T P
− γ+γβ yt−y = πt−1−π +γ yt−1−y into a rate rule using the IS curve yt − yP = −ζy (rt−1 − r∗):
1 ∗ T P ζy γ+γβ (rt−1−r )= πt−1−π +γ yt−1−y
∗ 1TP (rt−1−r )= 1 πt−1−π +γ yt−1−y
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The And Our Macro Model
Writing this rule as:
∗ 1 T P rt=r + 1 πt−π +γ yt−y
Which is the same form as the Taylor rule.
Ifwesetζy =γ=β=1,therulebecomes
rt = r∗ + 1 πt − πT + 1 yt − yP 22
which is the Taylor rule.
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