Tiểu luận môn đầu tư tài chính the role of expectations in monetary policy

Lucas Critique of Policy EvaluationPolicy conduct: Rules or Discretion The role of credibility and a Nominal Anchor Applications Approaches to Establishing Central Bank Credibility Summa

Monetary Policy

Monetary Policy

GVHD: TS Trần Ngọc Thơ

Nhóm :Đinh Xuân MinhHoàng Thị Thu Hà

Lucas Critique of Policy Evaluation

Policy conduct: Rules or Discretion

The role of credibility and a Nominal Anchor Applications

Approaches to Establishing Central Bank Credibility Summary

Expandation

∗ Economists have long used macroeconometric models to forecast economic activity and to evaluate the potential effects of policy options

∗ In essence, the models are collections of equations that describe statistical relationshops among many economic variables

∗ Economists can feed data into such models, which then churn out a forecast

or prediction

∗ To understand Lucas’s argument, we must first understand how econometric policy

evaluation is done For example: Federal Reserve wants to evaluate the potential effects

of changes in the federal funds rate from the existing level of 5%.Using conventional methods, the Fed economists would feed different fed funds rate options—say, 4% and 6%—into a computer version of the model

∗ The model wouldthen predict how unemployment and inflation would change under the different scenarios Then, the policymakers would select the policy with the most

desirable outcomes

∗ Relying on rational expectations theory, Lucas identified faulty reasoning in this approach

if the model does not incorporate rational expectations, as was true for

macroeconometric models used by policymakers at the time: When policies change,

public expectations will shift as well

∗ For example, if the Fed raises the federal funds rate to 6%, this action might change the way the public forms expectations about where interest rates will be in the future Those changing expectations, as we’ve seen, can have a real effect on economic behavior and outcomes

∗ Let’s now apply Lucas’s argument to a concrete example involving only one equation typically found in econometric models: the term structure equation.

∗ The term structure equation relates the long-term interest rate to current and past

values of the short-term interest rate

∗ It is one of the most important equations in macroeconometric models because the term interest rate, not the short-term rate, is the one believed to have the larger impact

long-on aggregate demand

∗ In Chapter 6, we learned that the long-term interest rate is related to an average of expected future short-term interest rates Suppose that in the past, when the shortterm rate rose, it quickly fell back down again; that is, any increase was temporary.

∗ Because rational expectations theory suggests that any rise in the short-term interest rate is expected to be only temporary, a rise should have only a minimal effect on the average of expected future short-term rates

∗ Suppose the Fed wants to evaluate what will happen to the economy if it pursues a policy that is likely to raise the short-term interest rate from a current level of 3% to a

permanently higher level of 5% The term structure equation that has been estimated using past data will indicate that just a small change in the long-term interest rate will occur

∗ However, if the public recognizes that the short-term rate is rising to a permanently

higher level, rational expectations theory indicates that people will no longer expect a rise in the short-term rate to be temporary

Application: The Term Structure of Interest Rates

∗ Instead, when they see the interest rate rise to 5%, they will expect the average of future short-term interest rates to rise substantially, and so the long-term interest rate will rise greatly, not minimally as the estimated term structure equation suggests.

∗ The term structure application demonstrates another aspect of the Lucas critique The effects of a particular policy depend critically on the public’s expectations about the

policy If the public expects the rise in the short-term interest rate to be merely

temporary, the response of long-term interest rates, as we have seen, will be negligible

Application: The Term Structure of Interest Rates

∗ The Lucas critique points out not only that conventional econometric models cannot be used for policy evaluation, but also that the public’s expectations about a policy will influence the response to that policy.

∗ The Lucas critique should also apply, however, to sectors of the economy for which rational expectations theory is more controversial, because the basic principle of the Lucas critique is not that expectations are always rational but rather that the formation

of expectations changes when the behavior of a forecasted variable changes

Application: The Term Structure of Interest Rates

∗ The Lucas critique exposed the need for new policy models that reflected the insights of rational expectations theory Here, we explore the implications of the critique on a long running debate among economists: whether monetary policymakers should have the flexibility to adapt their policy to a changing situation, or whether they should adopt rules, binding plans that specify how policy will respond (or not respond) to particular data such as unemployment and inflation.

∗ Policymakers operate with discretion when they make no commitment to future actions, but instead make what they believe in that moment to be the right policy decision for the situation.

∗ The time-inconsistency problem we discussed in Chapter 16 reveals the potential

limitations of discretionary policy Recall that the time-inconsistency problem is the

tendency to deviate from good long-run plans when making short-run decisions

Discretion and the Time-inconsistency

∗ Policymakers are always tempted to pursue a policy that is more expansionary than firms

or people expect because such a policy would boost economic output (and lower

unemployment) in the short run The best policy, however, is not to pursue expansionary

policy, because decisions about wages and prices reflect workers’ and firms’

expectations about policy (an implication of the rational expectations revolution)

Discretion and the Time-inconsistency

∗ When workers and firms see a central bank, for example, pursuing discretionary

expansionary policy, they will recognize that this is likely to lead to higher inflation in the future They will therefore raise their expectations about inflation, driving wages and prices up

∗ Policymakers will have better inflation performance in the long run if they do not try to surprise people with an unexpectedly expansionary policy, but instead keep inflation under control One way to do this is to abandon discretion and adopt rules to govern policy making

Discretion and the Time-inconsistency

∗ Rules are essentially automatic One famous type of rule, advocated by Milton Friedman and his followers who are known as monetarists, is the constant-money-growth-rate rule, in which the money supply is kept growing at a constant rate regardless of the

state of the economy

∗ Other monetarists such as Bennett McCallum and Alan Meltzer have proposed variants of this rule that allow the rate of money supply growth to be adjusted for shifts in velocity, which has often been found to be unstable in the short run

∗ Rules of this type are nonactivist because they do not react to economic activity

Types of Rules

∗ Activist rules, in contrast, specify that monetary policy should react to the level of output

as well as to inflation The most famous rule of this type is the Taylor rule, which we

discussed in Chapter 16 It specifies that the Fed should set its federal funds rate target

by a formula that considers both the output gap (Y − YP) and the inflation gap ( - T)

∗  

Types of Rules

∗ If monetary policymakers operate with discretion, they will be tempted to pursue overly expansionary monetary policies to boost employment in the short run but generate higher inflation (and no higher employment) in the long run.

∗ A commitment to a policy rule solves the time-inconsistency problem because

policymakers have to follow a set plan that does not allow them to exercise discretion and try to exploit the short-run tradeoff between inflation and employment

The Case for Rules

∗ Another argument for rules is that policymakers and politicians cannot be trusted Milton

Friedman and Anna Schwartz’s monumental work, A Monetary History of the United

States,4 documents numerous instances in which the Federal Reserve made serious

policy errors, with the worst occurring during the Great Depression, when the Fed just stood by and let the banking system and the economy collapse (Chapter 9 and Chapter

14 discuss the Fed’s actions during the Great Depression)

The Case for Rules

∗ The politicians who make fiscal policy are also not to be trusted because they have

strong incentives to pursue policies that help them win the next election They are

therefore more likely to focus on increasing employment in the short run without

worrying that their actions might lead to higher inflation further down the road

∗ Their advocacy for expansionary policies can then lead to the so-called political business cycle in which fiscal and monetary policy is expansionary right before elections, with higher inflation following later

The Case for Rules

The Case for Rules

The Case for Discretion

∗ First, rules can be too rigid because they cannot foresee every contingency For example, almost no one could have predicted that problems in one small part of the financial

system, subprime mortgage lending, would lead to the worst financial crisis in over 70 years, with such devastating effects on the economy

∗ The second problem with policy rules is that they do not easily incorporate the use of judgment Monetary policy is as much an art as a science Monetary policymakers need

to look at a wide range of information in order to decide on the best course for monetary policy, and some of this information is not easily quantifiable

The Case for Discretion

∗ Third, no one really knows what the true model of the economy is, and so any policy rule that is based on a particular model will prove to be wrong if the model is not correct Discretion avoids the straightjacket that would lock in the wrong policy if the model that was used to derive the policy rule proved to be incorrect

∗ Fourth, even if the model were correct, structural changes in the economy would lead to changes in the coefficients of the model The Lucas critique, which points out that

changes in policies can change the coefficients in macroeconometric models, is just one example

The Case for Discretion

Constrained Discretion

∗ The distinction between rules and discretion has strongly influenced academic debates about monetary policy for many decades But the distinction may be too stark As we have seen, both rules and discretion are subject to problems, and so the dichotomy between rules and discretion may be too simple to capture the realities that macroeconomic

policymakers face

∗ Discretion can be a relatively undisciplined approach that leads to policies that change with the personal views of policymakers or with the direction of political winds

Constrained Discretion

∗ Or it might operate within a more clearly articulated framework, in which the general

objectives and tactics of the policymakers—although not their specific actions—are

committed to in advance Ben Bernanke, now chairman of the Federal Reserve, along with the author of this textbook, came up with a name for this type of framework, constrained discretion.

∗ Constrained discretion imposes a conceptual structure and inherent discipline on

policymakers, but without eliminating all flexibility It combines some of the advantages ascribed to rules with those ascribed to discretion

∗ An important way to constrain discretion is, as was earlier discussed in Chapter 16, by

committing to a nominal anchor, a nominal variable—such as the inflation rate, the money

supply, or an exchange rate— that ties down the price level or inflation to achieve price stability

∗ If the commitment to a nominal anchor has credibility—that is, it is believed by the public

—it has important benefits

∗ First, a credible nominal anchor has elements of a behavior rule Just as rules help to

prevent the time-inconsistency problem in parenting by helping adults to resist pursuing the discretionary policy of giving in, a nominal anchor can help overcome the

timeinconsistency problem by providing an expected constraint on discretionary policy

∗ If monetary policymakers commit to a nominal anchor of achieving a specific inflation

objective, a 2% inflation rate, then they know that they will be subject to public scrutiny and criticism if they miss this objective or pursue policies that are clearly inconsistent with this objective, such as an interest rate target that is too low

∗ Second, a credible commitment to a nominal anchor will help to anchor inflation

expectations, which leads to smaller fluctuations in inflation It thus contributes to price stability, but also helps stabilize aggregate output Credibility of a commitment to a

nominal anchor is therefore a critical element in enabling monetary policy to achieve both

of its objectives, price stability and stabilizing economic activity

=> Our aggregate demand and supply analysis thus yields the following conclusion:

Monetary policy credibility has the benefit of stabilizing inflation in the short run when faced with positive demand shocks.

2 3

∗ =>We have the following additional result: Monetary policy credibility has the benefit

of stabilizing economic activity in the short run when faced with negative

demand shocks.

3

=>We reach the following conclusion: Monetary policy credibility has the benefit of producing better outcomes on both inflation and output in the short run when faced with negative supply shocks.

∗ In 1973, 1979, and 2007, the U.S economy was hit by three major negative supply shocks when the price of oil rose sharply; yet in the first two episodes, inflation rose sharply,

whereas in the most recent episode it rose much less, as we can see in panel (a) of Figure 3

∗ In the case of the first two episodes, monetary policy credibility was extremely weak

because the Fed had been unable to keep inflation under control, which had resulted in high inflation

∗ In contrast, when the third oil price shock hit in 2007–2008, inflation had been low and stable for quite a period of time, so the Fed had more credibility that it would keep inflation under control One reason that has been offered to explain why the last oil price shock

appears to have had a smaller effect on inflation in the recent episode is that monetary policy has been more credible Our aggregate demand and supply analysis provides the reasoning behind this view

∗ In the first two episodes, in which the commitment to a nominal anchor and credibility were weak, the oil price shocks would have produced a surge in inflation expectations and

a large upward and leftward shift in the short-run aggregate supply curve to AS3 in Figure

2 Thus, the aggregate demand and supply analysis predicts there would be a sharp

contraction in economic activity and a sharp rise in inflation This is exactly what we see in panels (a) and (b) of Figure 3