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Chapter 17: Q. 9 (page 468)

Why might inflation targeting increase support for the independence of the central bank in conducting monetary policy?

Short Answer

Expert verified

Because of greater transparency in policymaking, increased accountability, and, most importantly, public support, the central bank pursues an inflation-targeting monetary policy on its own.

Step by step solution

01

Concept Introduction

Monetary policy is the central bank's macroeconomic policy. It entails changes in the money supply and interest rate in order to achieve macroeconomic goals such as inflation, output growth, and employment.

02

Explanation

Inflation targeting is a central bank monetary policy in which the rate of inflation is fixed and targeted as its goal, and the fixed rate of inflation is announced to the public.

Because of greater transparency in policymaking, increased accountability, and, most importantly, public support, the central bank pursues an inflation-targeting monetary policy on its own.

The success of well-defined inflation targeting monetary policy would boost public support for central bank's independence and policies.

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Most popular questions from this chapter

Why is a public announcement of numerical inflation rate objectives important to the success of an inflation-targeting central bank?

What methods have inflation-targeting central banks used to increase communication with the public and to increase the transparency of monetary policymaking?

. 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?

The Fed鈥檚 maximum employment mandate is generally interpreted as an attempt to achieve an unemployment rate that is as close as possible to the natural rate and inflation that is close to its 2%goal for personal consumption expenditure price inflation. Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and a measure of the natural rate of unemployment (NROU). 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 unemployment rate, change the frequency setting to 鈥淨uarterly.鈥� Download the data into a spreadsheet. Calculate the unemployment gap and inflation gap for each quarter. Then, using the inflation gap, create an average inflation gap measure by taking the average of the current inflation gap and the gaps for the previous three quarters. Now apply the following (admittedly arbitrary and ad hoc) test to the data from 2000:Q1 through the most recent data available: If the unemployment gap is larger than 1.0for two or more consecutive quarters, and/ or the average inflation gap is larger in absolute value than 0.5for two or more consecutive quarters, consider the mandate 鈥渧iolated.鈥�

a. Based on this ad hoc test, in which quarters has the Fed 鈥渧iolated鈥� the price stability portion of its mandate? In which quarters has the Fed 鈥渧iolated鈥� the maximum employment mandate?

b. Is the Fed currently 鈥渋n violation鈥� of its mandate?

c. Interpret your results. What does your response to part (a) and the data imply about the challenge that monetary policymakers face in achieving the Fed鈥檚 mandate perfectly at all times?

What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy?
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