20. Class 20

Monetary policy rule
Contents
• Monetary policy
The channels of monetary policy transmission
 Another practical difficulty faced by monetary policymakers is determining

exactly how monetary policy affects the economy.
First: According to Keynesian IS-LM analysis, a reduction in the money supply

raises real interest rates, which in tun reduces aggregate demand. Declining
aggregate demand leads to falling output and prices. The effects of monetary
policy on the economy that work through changes in real interest rate are the
interest rate channel of monetary policy.
The channels of monetary policy transmission
Second: in open economy, a tightening of monetary policy raises the real exchange rate.
A higher real exchange rate, by making domestic good more expensive for foreigners and
foreign goods cheaper for domestic residents, reduces the demand for the home country’s
next exports. All else being equal, this reduced demand for net exports also reduces
aggregate demand, depressing output and prices. The effects of monetary policy working
through changes in the real exchange rate are called the exchange rate channel.
According to some economists, a tightening of monetary policy also works by reducing

both the supply of and demand for credit, a mechanism referred to as the credit channel
of monetary policy.
Rule versus discretion
Most classicals and Keynesians agree that money is neutral in the long run so that
changes in money growth affect inflation but not real variables in the long-run.
Therefore, most would agree that the main long-run goal of the monetary policy
should be to maintain a low and stable inflation rate.
The use of rule in monetary policy has been advocated primarily by a group of
economists called monetarists, and also by classical macroeconomists.
Supporters of rules believe that monetary policy should be essentially automatic.

In particular, in its control of money supply, the central bank should be required to
follow a set of simple, prespecified, and publicly announced rules.
For example, the Fed might be instructed to increase the Monterey base by 1%
each quarters.
 Monetary rules should be simple.
 There cannot be dozens of exceptions and conditions.
 The rule should be stated in terms of variables that the Fed can control directly or nearly
directly.
 Fed can control the monetary base precisely, a prespecified growth rate for the monetary
base is acceptable as a rule.
 But as the Fed’s control over, say, the national unemployment rate is indirect and
imperfect, an instruction to the Fed to “keep the unemployment rate at 4%” is not
acceptable.
Discretion
 The opposite of the rules approach which has been supported by most Keynesian economists, is
called Discretion.
 The idea behind discretion is that central bank should be free to conduct monetary policy in any way
that it believes will advances the ultimate objectives of low and stables inflation, high economic
growth, and low unemployment.
 The central bank should continuously monitor the economy and, using the advice of economic
experts, should change the money supply as needed to best achieve its goals.
 Because the strategy of discretion involves active responses by the central bank to changes in
economic circumstances, such a strategy sometime is called activist.
 The idea that giving the central bank the option of responding to changing
economic conditions as it sees fit is always better than putting monetary policy in
straitjacket dictated by rules is the essence of the Keynesian case for discretion.
The monetarist case for Rules
 Monetarism emphasizes the importance of monetary factors in the macroeconomy.
 Milton Friedman argued that monetary policy should be conducted by rules, and this idea has
become an important part of monetarist doctrine.
 Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the
longer run, however, changes in the money supply have their primary effect on the price
level.
 Proposition 2: Despite the powerful short run effects of money on the economy, there is little
scope for using monetary policy actively to try to smooth business cycles.
The monetarist case for Rules
• Proposition 3: Even if there is some scope for using monetary policy to smooth
business cycles, the fed cannot be relied on to do so effectively. Fed is susceptible
to short-run political pressures form the president and other in the administration.
• Proposition 4: The fed should choose a specific monetary aggregate (Such as M1

or M2) and commit itself to making the aggregate grow at fixed percentage rate
year in or year out.
Central bank credibility
 Much of the monetarist argument for rules rests on pessimism about the competence
or political reliability of the federal reserve. Economist who are more optimistic about
the ability of the govt. to intervene effectively in the economy question the monetarist
case for rules.
 The new argument for rules is a challenge even to policy optimists. It holds that the
use of monetary rules can improve the credibility of the central bank, or the degree
to which the public believes central bank announcement about future policy, and that
the credibility of the central bank influences how well monetary policy works.
Central bank credibility
 One reason that the central bank’s credibility matters is that people’s expectations of
the central bank’s actions affects their behavior .
 For example, central bank announces that it intends to maintain a stable price level by
maintaining a stable money supply.
 If firms collectively believe that the central bank will abide by its stated intention to
maintain a stable money supply, they will not increase their prices because they realize
that the central bank will allow the drop in output and employment to occur and the
firms will have to reduce prices in the future anyways.
Rational expectations
 What is rational expectations?
In economics, rational expectations refer to the assumption that individuals

and firms make predictions about the future based on all available
information in an unbiased and informed way.
It suggests that people use their understanding of the economic environment,
including historical data and economic theories, to make forecasts that, on
average, turn out to be accurate.
Rational expectations
Rational expectations theory is fundamental in macroeconomics, particularly in

New Classical Economics and Real Business Cycle Theory, where it challenges
the effectiveness of government intervention in influencing economic outcomes
due to agents’ ability to predict and counteract the effects of such policies.
Numerical problems
A. The money supply is $6,000,000, currency held by the public is $2,000,000, and the reserve-
deposit ratio is 0.25. Find deposits, bank reserves, the monetary base, and the money multiplier.
B. In a different economy, vault cash is $1,000,000, deposits by depository institutions at the central
bank are $4,000,000, the monetary base is $10,000,000, and bank deposits are $20,000,000. Find
bank reserves, the money supply, and the money multiplier.
• Money Supply (M) M = C + D

• Reserve to Deposit ratio rr = R/D
• Monetary base (B) = C + R
• Money Multiplier m = M/B
• Bank Reserves = VC + DCV (Vault cash (VC), deposits by depository institutions at the central
bank (DCV)).
Numerical problem
 When the real interest rate increases, banks have an incentive to lend a greater portion of their deposits, which
reduces the reserve-deposit ratio. In particular, suppose that
res = 0.4 - 2r,
where res is the reserve-deposit ratio and r is the real interest rate. The currency-deposit ratio is 0.4, the price level is
fixed at 1.0, and the monetary base is 60. The real quantity of money demanded is
L(Y, i) = 0.5Y - 10i,
where Y is real output and i is the nominal interest rate. Assume that expected inflation is zero so that the nominal
interest rate and the real interest rate are equal.
A. If r = i = 0.10, what are the reserve-deposit ratio, the money multiplier, and the money supply? For what real
output, Y, does a real interest rate of 0.10 clear the asset market?
B. Repeat Part (a) for r = i = 0.05.
C. Suppose that the reserve-deposit ratio is fixed at the value you found in Part (a) and isn't affected by interest rates.
If r = i = 0.05, for what output, Y, does the asset market clear in this case?
D. Is the LM curve flatter or steeper when the reserve deposit ratio depends on the real interest rate than when the
reserve-deposit ratio is fixed? Explain your answer in economic terms
Resources
• Chapter 14: Monetary policy and Federal Reserve system
• Macroeconomics by Abel, Bernanke and Croushore, 7th Edition

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Monetary policy rule

 Another practical difficulty faced by monetary policymakers is determining

First: According to Keynesian IS-LM analysis, a reduction in the money supply

According to some economists, a tightening of monetary policy also works by reducing

Supporters of rules believe that monetary policy should be essentially automatic.

 Monetary rules should be simple.

 There cannot be dozens of exceptions and conditions.

 Monetarism emphasizes the importance of monetary factors in the macroeconomy.

become an important part of monetarist doctrine.

• Proposition 4: The fed should choose a specific monetary aggregate (Such as M1

 What is rational expectations?

In economics, rational expectations refer to the assumption that individuals

Rational expectations theory is fundamental in macroeconomics, particularly in

• Money Supply (M) M = C + D

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