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Chapter 17: Q. 20 (page 468)
What are the main criteria for choosing a policy instrument? Why? Explain.
Observability and measurability
Controllability
Predictable effects on goal
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鈥淚nterest rates can be measured more accurately and quickly than reserve aggregates; hence an interest rate is preferred to the reserve aggregates as a policy instrument.鈥� Do you agree or disagree? Explain your answer
Why is a public announcement of numerical inflation rate objectives important to the success of an inflation-targeting central bank?
. Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), real GDP (GDPC1), an estimate of potential GDP (GDPPOT), and the federal funds rate (DFF). For the price index, adjust the units setting to 鈥淧ercent Change From Year Ago鈥� to convert the data to the inflation rate; for the federal funds rate, change the frequency setting to 鈥淨uarterly.鈥� Download the data into a spreadsheet. Assuming the inflation target is 2% and the equilibrium real fed funds rate is 2%, calculate the inflation gap and the output gap for each quarter, from 2000 until the most recent quarter of data available. Calculate the output gap as the percentage deviation of output from the potential level of output.
a. Use the output and inflation gaps to calculate, for each quarter, the fed funds rate predicted by the Taylor rule. Assume that the weights on inflation stabilization and output stabilization are both 陆 (see the formula in the chapter). Compare the current (quarterly average) federal funds rate to the federal funds rate prescribed by the Taylor rule. Does the Taylor rule accurately predict the current rate? Briefly comment.
b. Create a graph that compares the predicted Taylor rule values with the actual quarterly federal funds rate averages. How well, in general, does the Taylor rule prediction fit the average federal funds rate? Briefly explain.
c. Based on the results from the 2008鈥�2009 period, explain the limitations of the Taylor rule as a formal policy tool. How do these limitations help explain the use of nonconventional monetary policy during this period?
d. Suppose Congress changes the Fed鈥檚 mandate to a hierarchical one in which inflation stabilization takes priority over output stabilization. In this context, recalculate the predicted Taylor rule value for each quarter since 2000, assuming that the weight on inflation stabilization is 戮 and the weight on output stabilization is 录. Create a graph showing the Taylor rule prediction calculated in part (a), the prediction using the new 鈥渉ierarchical鈥� Taylor rule, and the fed funds rate. How, if at all, does changing the mandate change the predicted policy paths? How would the fed funds rate be affected by a hierarchical mandate? Briefly explain.
e. Assume again equal weights of 陆 on inflation and output stabilization, and suppose instead that beginning after the end of 2008, the equilibrium real fed funds rate declines by 0.05 each quarter (i.e. 2009:Q1 is 1.95, then 1.90, etc.), and once it reaches zero, it remains at zero thereafter. How does it affect the prescribed fed funds rate? Why might this be important for policymakers to take into consideration?
. Since monetary policy changes made through the fed funds rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate, rather than the current inflation rate. In light of this, suppose that monetary policymakers employ the Taylor rule to set the fed funds rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the inflation and output gaps are 陆, the equilibrium real fed funds rate is 4%, the inflation rate target is 3%, and the output gap is 2%. a. If the expected inflation rate is 7%, then at what target should the fed funds rate be set according to the Taylor rule?
b. Suppose half of Fed economists forecast inflation to be 6%, and half of Fed economists forecast inflation to be 8%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according to the Taylor rule?
c. Now suppose half of Fed economists forecast inflation to be 0%, and half forecast inflation to be 14%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according to the Taylor rule?
d. Given your answers to parts (a)鈥�(c) above, do you think it is a good idea for monetary policymakers to use a strict interpretation of the Taylor rule as a basis for setting policy? Why or why not?
Many countries have central banks that are responsible for their nation鈥檚 monetary policy. Go to http:// www.bis.org/cbanks.htm, and select one of the central banks (for example, the central bank of Norway). Review that bank鈥檚 website to determine its policies regarding the application of monetary policy. How does this bank鈥檚 policies compare to those of the U.S. central bank?
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