Monetary Policy and Inflation.

The relationship between the GDP gap and the rate of inflation

The above graph shows the relationship between the GDP Gap and that the rate of
inflation. Though the relationship between the GDP gap the inflation rate is positive,
there is a delay between changes in the GDP gap and the rate of inflation. This is to say
that, in general, increases (decreases) in the GDP gap result in the rate of inflation
increasing (decreasing) a year later. The delayed response of inflation is because of sticky
prices.

Notice that even when real GDP equals potential, there is still inflation. Even when real
GDP is below potential, inflation persists, though at a lower rate. A fall in real GDP
below potential GDP leads to disinflation, not deflation.

The reasons inflation persists even when real GDP equals potential are because of
expectations and staggered wage contracts.

To get a better understanding of inflationary expectations consider the following graph

showing the relationship between the interest rate on a 10-year treasury bond and the rate
of inflation over the period spanning from January, 1960 up through October of 2006:
Important points highlighted by the above graph:
1. The period from 1964 through 1980 – The grate inflation
2. The period from 1980 through 1985. There was a sharp decline in the rate of
inflation but not in the 10-year bond rate.

Maintaining the goal of price stability

The key goal of the Fed is to maintain price stability. The Fed tries to achieve this goal by
preventing actual economic activity from deviating too much from potential GDP.
Otherwise large deviations result in imbalances that can lead either to sharp increases in
the rate of inflation or recessions.

There are many who believe that the high inflation experienced between the mid 1960s
up through 1980 was because the Federal Reserve was not committed to maintaining the
goal of price stability.

However, today, the Fed is committed to price stability. This is a point made by Ben
Bernanke in his February 15. 2006 testimony before Congress:

Another factor bearing on the inflation outlook is that the

economy now appears to be operating at a relatively high
 level of resource utilization. Gauging the economy's
sustainable potential is difficult, and the Federal Reserve
will keep a close eye on all the relevant evidence and be
flexible in making those judgments. Nevertheless, the
risk exists that, with aggregate demand exhibiting
considerable momentum, output could overshoot its
sustainable path, leading ultimately--in the absence of
countervailing monetary policy action--to further upward
pressure on inflation. In these circumstances, the FOMC
judged that some further firming of monetary policy may
be necessary, an assessment with which I concur.

Credibility and Accountability.

Credibility is the degree to which people and markets believe policy announcements will
actually be implemented and carried through.

If inflation is threatening, the Fed would seek to reduce spending, which, in turn, would
reduce the rate of inflation.

At one time, to reduce spending, the Federal Reserve would lower the money supply's
growth rate. In this case, the money supply is an example of what is referred to as an
intermediate target(See page 414 of Mishkin). Prior to the early 90s, two good arguments
for choosing M2 as an intermediate target according to an article by Bernanke and
Mishkin were (1) monetary targets act as a goal post or compass that help in choosing
1

the appropriate policy setting; (2) more importantly, monetary growth targets are useful
as signals that indicate the Fed’s intention to get tough with inflation.

This is important if the Fed is worried about credibility. If the Fed can reassure the
public, by targeting M2, that it is committed to controlling inflation, then it can eradicate
inflationary expectations. More specifically, there is a long lag between the Fed’s policy
actions and the actual reduction of inflation. Because of this long lag, it is hard for the
public to really understand the Fed’s true intentions. Changes in the money supply, on the
other hand, can be observed sooner than changes in the rate of inflation. If changes in the
money supply can be considered as indicator of inflation, then the public, by watching the
money supply, can gauge the credibility of the Fed's inflation combating policy.

The supposed relationship between the money supply and price stability can be
understood by using the equation of exchange and the quantity theory .The equation of
2

1Ben Bernanke and Fredrick Mishkin, “Central Bank Behavior and the Strategy of Monetary Policy:
Observations from Six Industrialized Countries.” NBER Macroeconomics Annual 1992, p. 186.
2 See Mishkin pp. 538-540.
exchange is written as:

MV = PY (1)

Where:
M ~ Money supply
V ~ Income velocity of money 3

P ~ Price level
Y ~ Real GDP.

The equation of exchange can also be written as:

M = kPY (2)

k = where k is the fraction of nominal GDP (PY) held as money balances.

According to the quantity theory, changes in the money supply leads to changes in
nominal GDP. In it's simplified form, k is assumed to be constant. This means the rate of
growth of nominal GDP is equal to the rate of growth of the money supply : 4

%∆ M = %∆ P + %∆ Y. (3)

According to this formulation, if real GDP is expected to grow at 2.5% per year and the
Fed is willing to accept a 2.5% rate of inflation (= %∆ P), the Fed targets the money
supply to grow at 5%. However because of unanticipated events, the Fed targets a range
for the money supply to grow within, with 5% being the midpoint. For example, the
monetary growth rate will be specified at 5% ± 2%., The money supply would grow at a
rate close to 7% if the economy were in a recession. Or, if there were an unanticipated
large GDP gap, the money supply would grow at close to 3%. The midpoint represents
the target rate needed to maintain the long-run objective of price stability. The range
represents how much the Fed is willing to deviate from its long-run objective in order to
maintain short-run stability.

To keep M2 growing at a particular rate, the Fed would adjust an operating target (see
page 415 of Mishkin) such as nonborrowed reserves.

A major problem, is that k has not been stable over the past 20 years. In other words, M2
no longer satisfies the criteria that M2 have a predictable effect on price stability and
economic growth. For further discussion about this issue, read pages 425-427 of
Mishkin).

3 The income velocity measures the number of times a dollar bill enters somebody's income in a given
period of time.
4 Concerning equation (3) realize that since k is assumed to remained constant, %∆ k = 0. Also, recall that
the percentage change of a product is equal to the sum of the percentage change of the product's
components. That is, %∆( PY) = %∆ P + %∆ Y.
The idea of a nominal anchor.

How are prices determined under an unbacked paper-monetary standard? What

determines whether a loaf of bread is worth $1 or $25 ? Or what determines whether the
5

nominal interest rate on a ten-year bond is 5 percent or 175 percent? When paper money
is intrinsically worthless, to tie down the purchasing power of money, monetary policy
has to be constrained. This constraint is called a nominal anchor.

A nominal anchor, by constraining monetary policy, acts to tie down inflationary

expectations. For example, when discussing controlling the money supply, the rate of
growth of the money supply acted as a nominal anchor. According to theory, if, over the
long run, the money supply grows at 5 percent, and real GDP grows at 3 percent, then the
rate of inflation will equal 2 percent. If the central bank commits to a monetary growth
rule of 5 percent, then the public will believe that inflation will, on average, equal 2
percent and form expectations accordingly.

The problem is that the relationship between money and economic activity no longer
holds. Since the early 1990s, the Fed has used interest rates instead of the money supply
as an intermediate target. The nature of how the Fed conducts policy can be described by
using a monetary policy rule referred to as the Taylor rule (described on pages 428-430
of Mishkin) : 6

The rule can be written as:

iff = π + .5y* + .5(π – π *) + rff (4)

where:

iff = nominal federal funds rate

π = rate of inflation
y* = the GDP gap – the percentage deviation between real and potential GDP.
π * = the target rate of inflation –– the rate of inflation that should prevail over the long
run, when the GDP gap is zero.
rff = equilibrium real federal funds rate -- what the Fed believes the real federal funds
rate would be when inflation is at the target rate.

To understand how this rule works, suppose the target rate of inflation is 2 percent, and
the GDP gap is zero. Assume as well that the real equilibrium federal funds rate equals 2

5 This example is from page 19 of Inflation Targeting, by Bernake, Ben S., Laubach, Thomas, Mishkin,
Frederic, and Posen, Adam, Princeton University Press, 1999.
6 John Taylor(1999), the originator of the Taylor rule, stated that the Taylor rule can be derived from the
quantity equation. To show that here is beyond the level of this course.
percent.

In that case , the monetary policy rule can be written as:

iff = π + .5(π − 2%) + 2% (5a)

= 1.5π +1% (5b)

This relationship, known as the monetary policy rule line, is depicted as a straight line in
the diagram below.

8 Monetary Policy Rule

7 Line
(iff = 1.5 π +1%)
6

Federal funds 5
rate (%) 4

3
Real Interest rate
2 equals 2 percent

0
0 1 2 3 4 5
Rate of Inflation (%)

Notice the slope of the monetary policy rule line shows how responsive the federal funds
rate is to changes in the rate of inflation. In this example, it has a slope of 1.5. This means
that for every 1 percentage point change in the rate of inflation, the federal funds rate
changes by 1.5 percentage points.

According to this rule, if the rate of inflation rises from 2 percent to 3 percent, the federal
funds rate will increase by 1.5 percentage points from 4 to 5.5 percent. Notice what
happens to the real interest rate. When the rate of inflation is 2 percent, the real interest
rate equals two percent. However, when the rate of inflation is 3 percent, the real rate
increases to 2.5 percent. Notice that as the rate of inflation increases, the gap between the
monetary policy rule line and the line representing a constant 2 percent real rate
increases. This shows that as the rate of inflation rises above the target rate, the larger the
increase in the real rate of interest.

If the rate of inflation falls below 2 percent, the Fed lowers the federal funds rate by more
than the decline in the rate of inflation. For example, if the rate of inflation falls from 2
percent to 1 percent, the federal funds rate will fall from 4 percent to 2.5 percent. In this
case the real rate of interest declines by 50 basis points from 2 percent to 1.5 percent. As
the rate of inflation decreases below the target level, the gap between the line
representing a constant 2 percent real rate and the monetary policy rule line increases.
This shows that the more the rate of inflation falls below the target rate, the larger the
decline in the real rate of interest.

According to this policy rule, an increase in the rate of inflation results in the Fed
increasing the federal funds rate by more than the increase in the inflation rate. This
results in an increase in the real rate of interest. A rise in the real interest rate reduces
spending which reduces the GDP gap. The reduction in the GDP gap, in turn, leads to a
reduction in the rate of inflation.

According to Mishkin, the Fed’s current policy can best be described as “just do it.” This
means that the Fed has an “implicit monetary anchor. To keep inflation under control,
monetary policy needs to be forward looking. Under Alan Greenspan and, so far, under
Ben Bernanke, the Fed has been forward looking

The suggests that implicitly or explicitly, the Fed is using interest rates to achieve an
inflation target. If the interest rate rises above the target rate, then the Fed raises the
federal funds rate. If inflation falls below the target rate, then the Fed lowers in the
federal funds rate.

The idea behind inflation targets is outlined in Mishkin on pages 501-507.

According to Mishkin, inflation targeting involves:
1. Public announcement of a medium-term numerical target for inflation.
2. An institutional commitment to price stability as the primary, long-run goal of
monetary policy and a commitment to achieve the goal.
3. An information-inclusive strategy in which many variables are used in making
decisions about monetary policy.
4. Increased transparency of the monetary policy strategy through communication
with the public and the markets about policy plans and objectives.
5. Increased accountability of the central bank for attaining inflation objectives.