Tiểu luận môn đầu tư tài chính THE ROLE OF EXPECTATIONS IN MONEYTARY POLICY

Name of members AssignmentsBùi Thị Như Ý • Translate and prepare slides for part I Lucas critique of Policy evaluation and part II Policy conduct: Rules or Discretion?.. Lucas Critique O

Name of members Assignments

Bùi Thị Như Ý

• Translate and prepare slides for part I (Lucas critique of Policy evaluation) and part II (Policy conduct: Rules or Discretion?).

Nguyễn Thị Mỹ Vân

• Translate and prepare slides for part III (The Role of Credibility and

A Nominal Anchor) and Part IV (Approaches to Establishing Central Bank Credibility)

• Prepare Extention part.

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• Discretionary policies could reduce the severity of business cycle fluctuations without creating inflation.

• In the 1960s and 1970s, these economists got their chance to put discretionary policies into practice, but the results were not what they had anticipated The economic record for that period is not a happy one: Inflation accelerated, the rate often climbing above 10%, while unemployment figures deteriorated from those of the 1950s

Reason

Their analysis cast doubt:

- On whether macroeconomic models can be used to evaluate the potential effects of policy

- On whether policy can be effective when the public expects that it will be implemented

Examines the analysis behind the rational expectations revolution of the Lucas critique.

Discuss the effect of rational expectations on the aggregate demand and supply analysis

Explore how this theoretical breakthrough has shaped current policy-making models and debates

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Lucas Critique Of Policy Evaluation

Econometric Policy Evaluation

Application: The Term Structure Of

Interest Rates

Application: The Term Structure Of

Interest Rates

Policy Conduct: Rules Or Discretion?

Discretion And The Time-Inconsistency

Problem

Discretion And The Time-Inconsistency

Problem

Types Of Rules

The Case For Rules.

FYI: The Political Business Cycle and

The Role Of Credibility And A Noninal anchor

Benefits Of A Credible Nominal Anchor

Credibility And Aggregate Demand Shocks

Credibility And Aggregate Supply Shocks

Application: A Tale Of Three Oil Price

Shocks

Application: A Tale Of Three Oil Price

Shocks

Credibility And Anti-Inflation Policy

Global: Ending the Bolivian Hyperinflation: A

Successful Anti-Inflation Program

Global: Ending the Bolivian Hyperinflation: A

Successful Anti-Inflation Program

Application: Credibility And The Reagan

Appoint “Conservative” Central Bankers

Inside the Fed: The Appointment of Paul Volcker, Anti-Inflation Hawk Inside the Fed: The Appointment of Paul Volcker, Anti-Inflation Hawk

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 relationships among many economic variables Economists can feed data into such models, which then churn out a forecast or prediction

Econometric Policy Evaluation: A Critique, Robert Lucas spurred the rational expectations revolution

by presenting a devastating argument against the use of macroeconometric models used at the time for evaluating policy

The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences The theory suggests that the current expectations in the economy are equivalent to what people think the future state of the economy will become This contrasts with the idea that government policy influences people's decisions.

The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences The theory suggests that the current expectations in the economy are equivalent to what people think the future state of the economy will become This contrasts with the idea that government policy influences people's decisions

Adaptive Expectations

• Expectations of inflation, for example, were typically viewed as

being an average of past inflation rates This view of expectation

formation, called adaptive expectations, suggests that changes in

expectations will occur slowly over time as past data change

• So if inflation had formerly been steady at a 5% rate, expectations

of future inflation would be 5%, too If inflation rose to a steady rate

of 10%, expectations of future inflation would rise toward 10%, but

slowly: In the first year, expected inflation might rise only to 6%; in

the second year, to 7%; and so on.

Rational Expectations

• Adaptive expectations have been faulted on the grounds that people use more information than just past data on a single variable to form their expectations of that variable Their expectations of inflation will almost surely be affected by their predictions of future monetary policy as well as by current and past monetary policy.

• In addition, people often change their expectations quickly in the light of new information To meet these objections to adaptive expectations, John Muth developed an alternative theory of expectations, called rational expectations, which can be stated as follows: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information

To explain it more clearly, let’s use the theory of rational expectations to examine how expectations are formed in a situation that most of us encounter at some point in our lifetime: our drive

to work Suppose that if Joe Commuter travels when it is not rush hour, it takes an average of 30 minutes for his trip Sometimes it takes him 35 minutes, other times 25 minutes, but the average non–rush-hour driving time is 30 minutes If, however, Joe leaves for work during the rush hour, it takes him, on average, an additional 10 minutes to get to work Given that he leaves for work during the rush hour, the best guess of the driving time—the optimal forecast—is 40 minutes

People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible.

People might be unaware of some available relevant information, so their best guess of the future will not be accurate

An expectation may fail to be rational for two reasons:

To understand Lucas’s argument, we must first understand how econometric policy evaluation is done For example, that the 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 would then predict how unemployment and inflation would change under the different scenarios Then, the policymakers would select the policy with the most desirable outcomes.

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 Yet econometric models that do not incorporate rational expectations ignore any effects of changing expectations, and thus are unreliable for evaluating policy options.

Econometric Policy Evaluation

The 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 long-term interest rate, not

the short-term rate, is the one believed to have the larger impact on aggregate demand.

In Chapter 6, we learned that the long-term interest rate is related to an average of expected future term interest rates

short-Application: The Term Structure of Interest Rates

Suppose that in the past, when the short - term 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 It will cause the long-term interest rate to rise by a negligible amount The term structure relationship estimated using past data will then show only a weak effect on the long-term interest rate of changes

in the short-term rate

Application: The Term Structure of Interest 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.

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 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.

Application: The Term Structure of Interest Rates

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

If, however, the public expects the rise to be more permanent, the response of long-term rates will be far greater

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.

Application: The Term Structure of Interest Rates

Sumary: The Lucas Critique

The term structure equation discussed here is only one of many equations in econometric models to which the Lucas critique applies In fact, Lucas uses the examples of consumption and investment equations

a forecasted variable changes

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 Empowering policymakers to shape policy on-the-fly introduces complexities

Recall that the time-inconsistency problem is the tendency to deviate from good long-run plans

when making short-run decisions

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)

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 The rise in wages and prices will lead to higher inflation, but may not result in higher output on average

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 problem

In contrast to discretion, rules are essentially automatic.

One famous type of rule, 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 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 Monetarists advocate rules of this type because they believe that money is the sole source of fluctuations in aggregate demand and because they believe that long and variable lags in the effects of monetary policy will lead to greater volatility in economic activity and inflation if policy actively responds to unemployment (as discussed in Chapter 23)

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 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 (π- πT).

As our discussion of the time-inconsistency problem suggests, discretionary monetary policy can lead

to poor economic outcomes

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 like the Taylor rule or the constant-money-growth-rate 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

Policymakers can achieve desirable long-run outcomes

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

Milton Friedman in A Monetary History of the United States, 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

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

FYI: The Political Business Cycle and Richard Nixon

 Richard Nixon and his aides took some extraordinary actions to ensure a landslide victory in the

FYI: The Political Business Cycle and Richard Nixon

 The Nixon episode led economists and political scientists to theorize that politicians would take steps to take themselves look good during election years

 The theory went, they would take steps to stimulate the economy before the election, leading to

a boom and low unemployment that would increase their electoral chances

FYI: The Political Business Cycle and Richard Nixon

 Unfortunately, the result of these actions would be higher inflation down the road, which then would require contractionary policies to get inflation under control later, with a resulting recession

in the future

 Although the Nixon episode provided support for the existence of a political business cycle, research has not come to a definitive answer regarding whether this phenomenon is a general one

Although policy rules have important advantages, they do have serious drawbacks.

 First, rules can be too rigid because they cannot foresee every contingency

 The second problem with policy rules is that they do not easily incorporate the use of judgment 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 Judgment is thus an essential element of good monetary policy, and it is very hard to write it into a rule Only with discretion can monetary policy bring judgment to bear

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

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

The distinction between rules and discretion has strongly influenced academic debates about monetary policy for many decades.

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 matter of degree 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 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

Constrained Discretion

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

Constrained Discretion

Constrained Discretion

Global: The Demise of Monetary Targeting in Switzerland

 In 1975 the Swiss National Bank (Switzerland’s central bank) adopted monetary targeting in which

aggregate M1

their growth rate target to an even narrower monetaryaggregate, the monetary base

 Although monetary targeting was quite successful in Switzerland for many years, it ran into serious problems with the introduction of a new interbank payment system, the Swiss Interbank Clearing (SIC), and a wide-ranging revision of commercial banks’ liquidity requirements in 1988

Global: The Demise of Monetary Targeting in Switzerland

 A smaller amount of the monetary base was now needed relative to aggregate spending, altering the relationship between the two, and so the 2% target growth rate for the monetary base was far too expansionary

 Inflation subsequently rose to over 5%, well above that of other European countries These problems with monetary targeting led the Swiss to abandon it in the 1990s and adopt a much more flexible framework for the conduct of monetary policy

Credibility and Aggregate Demand Shocks

Benefits of a Credible Nominal anchor

Credibility and Aggregate Supply Shocks

Credibility and Anti-Inflation policy

Global: Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program

Application: Credibility and the Reagan Budget Deficits

• 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

EX: if a central bank has an explicit target for the inflation rate, say, 2%, and takes steps to achieve this target,

then the inflation target becomes a nominal anchor Alternatively, a government could commit to a fixed exchange rate between its currency and a sound currency like the dollar and use this as its nominal anchor.

• If the commitment to a nominal anchor has

credibility—that is, it is believed by the public—it has important benefits.

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EX: if monetary policymakers commit to a nominal anchor of

achieving a specific inflation objective, say, 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 they will be less tempted to pursue overly expansionary, discretionary policies in the short run that will be inconsistent with their commitment to the nominal anchor.

A nominal anchor can help overcome the time- inconsistency problem by providing an expected constraint on discretionary

policy.

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It thus contributes to price stability, but also helps stabilize

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.

a credible commitment to a nominal anchor will help to anchor inflation expectations, which leads

to smaller fluctuations in

inflation

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Benefits of a Credible Nominal anchor

Credibility and Aggregate Demand Shocks

Credibility and Aggregate Supply Shocks

Credibility and Anti-Inflation policy

Global: Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program

Application: Credibility and the Reagan Budget Deficits

• Suppose businesses suddenly get new information that

makes them more optimistic about the future.

• So they increase their investment spending As a result of

this positive demand shock.

• The aggregate demand curve shifts to the right from AD1 to

AD2,

moving the economy from point 1 to point 2 Aggregate

output rises to Y2 and inflation rises above the inflation

LRAS

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Π2

Y2