Chapter 17 The Conduct of Monetary Policy Strategy and Tactics

The Economics of Money, Banking, and
Financial Markets
Thirteenth Edition
Global Edition
Chapter 17
The Conduct of Monetary
Policy: Strategy and Tactics
Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
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• This chapter examines the goals of monetary policy and
then considers one of the most important strategies for
the conduct of monetary policy, inflation targeting
Learning Objectives (1 of 2)
17.1 Define and recognize the importance of a nominal
anchor.
17.2 Identify the six potential goals that monetary policy
makers may pursue.
17.3 Summarize the distinctions between hierarchical and
dual mandates.
17.4 Compare and contrast the advantages and
disadvantages of inflation targeting.
17.5 Identify the key changes made over time to the
Federal Reserve monetary policy strategy.
Learning Objectives (2 of 2)
17.6 List the four lessons learned from the global financial
crisis and discuss what they mean to inflation targeting.
17.7 Summarize the arguments for and against central
bank policy response to asset-price bubbles.
17.8 Describe and assess the four criteria for choosing a
policy instrument.
17.9 Interpret and assess the performance of the Taylor
rule as a hypothetical policy instrument for setting the
federal funds rate.
The Price Stability Goal and the Nominal
Anchor
• 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
• The time-inconsistency problem
Other Goals of Monetary Policy
• Five other goals are continually mentioned by central
bank officials when they discuss the objectives of
monetary policy:
1. High employment and output stability

2. Economic growth
3. Stability of financial markets
4. Interest-rate stability
5. Stability in foreign exchange markets
Should Price Stability Be the Primary
Goal of Monetary Policy?
• Hierarchical versus Dual Mandates:
– Hierarchical mandates put the goal of price stability first,
and then say that as long as it is achieved other goals can
be pursued
– Dual mandates are aimed to achieve two coequal
objectives: price stability and maximum employment
(output stability)
• Price Stability as the Primary, Long-Run Goal of Monetary
Policy
– Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the long
run but not the short run.
Inflation Targeting (1 of 3)
• 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
• New Zealand (effective in 1990)
– Inflation was brought down and remained within the target
most of the time.
– Growth has generally been high, and unemployment has
come down significantly.
• Canada (1991)
– Inflation decreased since 1991; some costs in term of
unemployment
• United Kingdom (1992)
– Inflation has been close to its target.
– Growth has been strong, and unemployment has been
decreasing.
Figure 1 Inflation Rates and Inflation Targets for New
Zealand, Canada, and the United Kingdom, 1980–2020
• Advantages:
– Reduces potential of falling in time-inconsistency trap
– Easily understood
– Stresses transparency and accountability
– Consistency with democratic principles
– Improved perfomance
• Disadvantages:
– Delayed signaling
– Too much rigidity
– Potential for increased output fluctuations
– Low economic growth during disinflation
The Evolution of the Federal Reserve’s
Monetary Policy Strategy (1 of 2)
• The United States has achieved excellent macroeconomic
performance (including low and stable inflation) until the
onset of the global financial crisis without using an explicit
nominal anchor such as an inflation target.
• History:
– Fed began to announce publicly targets for money
supply growth in 1975
– Paul Volker (1979) focused more in non-borrowed
reserves
– Greenspan announced in July 1993 that the Fed would
not use any monetary aggregates as a guide for
conducting monetary policy
Monetary Policy Strategy (2 of 2)
• There is no explicit nominal anchor in the form of an overriding
concern for the Fed.
• Forward looking behavior and periodic “preemptive strikes”
• The goal is to prevent inflation from getting started.
• Advantages
– Uses many sources of information
– Demonstrated success
• Disadvantages
– Lack of accountability
– Inconsistent with democratic principles
The Fed’s “Just Do It” Monetary Policy
Strategy
• Advantages of the Fed’s “Just Do It” Approach:
– forward-looking behavior and stress on price
stability also help to discourage overly expansionary
monetary policy, thereby ameliorating the time-
inconsistency problem
• Disadvantages of the Fed’s “Just Do It” Approach:
– lack of transparency; strong dependence on the
preferences, skills, and trustworthiness of the
individuals in charge of the central bank
Monetary Policy Strategy
• Advantages
– Uses many sources of information
– Demonstrated success
• Disadvantages
– Lack of accountability
– Inconsistent with democratic principles
Inside the Fed: Ben Bernanke’s Advocacy
of Inflation Targeting
• While a professor at Princeton, Bernanke, in several

articles and in a book cowritten with the author of this
book, argued that inflation targeting would be a major
step forward for the Federal Reserve and would produce
better economic outcomes, for many of the reasons
outlined earlier. When Bernanke took his position as a
governor of the Federal Reserve from 2002 to 2005, he
continued to advocate the adoption of an inflation target.
Global: The European Central Bank’s
Monetary Policy Strategy
• The European Central Bank (ECB) has also been slow
to move toward inflation targeting, adopting a hybrid
monetary strategy that includes some elements of
inflation targeting.
Lessons for Monetary Policy Strategy
from the Global Financial Crisis
1. Developments in the financial sector have a far greater
impact on economic activity than was earlier realized.
2. The zero-lower-bound on interest rates can be a
serious problem.
3. The cost of cleaning up after a financial crisis is very
high.
4. Price and output stability do not ensure financial
stability.
Implications for Inflation Targeting
• Level of the Inflation Target
• Flexibility of Inflation Targeting
Inside the Fed: The Fed’s New Monetary
Policy Strategy: Average Inflation Targeting
• In August 2020, the Federal Reserve announced that it

would now target an average inflation rate of 2%.
• Past inflation rates, as a result, would now affect its
target in the short run.
Should Central Banks Respond to
Bubbles?
• How should Central banks respond to asset price
bubbles?
– Asset-price bubble: pronounced increase in asset
prices that depart from fundamental values, which
eventually burst.
• Types of asset-price bubbles
– Credit-driven bubbles
▪ Subprime financial crisis
▪ Bubbles driven by irrational exuberance
Bubbles? (1 of 2)
• The “Greenspan doctrine”: monetary policy should not be used to
prick bubbles.
– asset-price bubbles are nearly impossible to identify
– raising interest rates may be very ineffective in limiting bubbles
because market participants expect such high rates of return
from buying bubble-driven assets
– monetary policy actions are a blunt instrument and likely to
affect asset prices in general, rather than the specific assets
that are experiencing a bubble
– monetary policy actions to prick bubbles can have harmful
effects on the aggregate economy.
– timely monetary policy can keep the harmful effects of a
bursting bubble can be kept at a manageable level
Bubbles? (2 of 2)
• Macropudential policy: regulatory policy to affect what
is happening in credit markets in the aggregate.
• Monetary policy: Central banks and other regulators
should not have a laissez-faire attitude and let credit-
driven bubbles proceed without any reaction.
Tactics: Choosing the Policy Instrument
• Tools
– Open market operation
– Reserve requirements
– Discount rate
• Policy instrument (operating instrument)
– Reserve aggregates
– Interest rates
– May be linked to an intermediate target
• Interest rate and aggregate targets are incompatible
(must choose one or the other).
Figure 2 Linkages Among Central Bank Tools, Policy
Instruments, Intermediate Targets, and Goals of
Monetary Policy
Figure 3 Result of Targeting on
Nonborrowed Reserves
Figure 4 Result of Targeting on the
Federal Funds Rate
Criteria for Choosing the Policy
Instrument
• Observability and Measurability
• Controllability
• Predictable effect on Goals
Tactics: The Taylor Rule
Federal funds rate target 
inflation rate  equilibrium real fed funds rate
1/ 2 (inflation gap)  1/ 2 (output gap)
• An inflation gap and an output gap

– Stabilizing real output is an important concern
– Output gap is an indicator of future inflation as
shown by Phillips curve
• NAI RU
– Rate of unemployment at which there is no tendency
for inflation to change
Figure 5 The Taylor Rule for the Federal
Funds Rate, 1960–2020
Source: Calculations with Federal Reserve Bank of St. Louis F RED database:
https://fred.stlouisfed.org/series/PCEPILFE ; https://fred.stlouisfed.org/series/GDPC1 ;
https://fred.stlouisfed.org/series/GDPPOT ; https://fred.stlouisfed.org/series/FEDFUNDS .
Inside the Fed: The Fed’s Use of the
Taylor Rule
• Putting monetary policy on autopilot by using a Taylor rule
with fixed coefficients is problematic. The Taylor rule is
useful, however, as a guide to monetary policy.
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The Economics of Money, Banking, and

1. High employment and output stability

• While a professor at Princeton, Bernanke, in several

• In August 2020, the Federal Reserve announced that it

• An inflation gap and an output gap

This work is protected by United States copyright laws and is

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