Implementing Monetary Policy

ImplementingMonetaryPolicyCarlE.WalshUniversityofCalifornia,SantaCruzApril2010AbstractDuringthepastthreeyears,centralbankshavefacedchallengesthatfewforesawduringtheperiodknownastheGreatModeration.Duringthecrisis,centralbankshaverespondedwithtraditionalin-terestratetools,beenforcedtodealwiththezerolowerboundonnominalinterestrates,andexpandedthescopeoftheirlenderoflastresortfunction.Inaddition,quantitativeeasingandcrediteasingpoli-cieshaveenteredthetoolkitofcentralbanks.Afterbrie‡ydiscussingtheinstrumentsofmonetarypolicyandreviewingtheperformanceofin‡ationtargeting,Iconsiderthreesuggestedmodi…cationstothispolicyframework.Theseareraisingtheaveragetargetforin‡ation,incorporatingadditionalobjectives,andswitchingtopriceleveltar-geting.1IntroductionDuringthepastthreeyears,centralbankshavefacedchallengesthatfewforesawduringtheperiodknownastheGreatModeration.Thecrisisin…nancialmarketsandthemostsevereglobalrecessionsincethe1930s,com-binedwiththelimitationsimposedonconventionalmonetarypolicytoolsbythezerolowerboundonnominalinterestrates,hasleadtonewthinkingontheimportanceof…nancialstability,therolesof…nancialfrictions,theappropriategoalsofmonetarypolicy,andtherangeoftoolsthatcanbeusedtoachievethosegoals.Ofcourse,priortotherecentcrisis,manycountries,includingKorea,hadexperienced…rsthandtheeconomicdisruptionsposedbyexchangerateandDepartmentofEconomics,UCSantaCruz,1156HighSt.,SantaCruz,CA95064,[e-mail]2010BankofKoreaInternationalConference,May31-June1,2010.(walsh_bok_20100422.tex)1…nancialcrises.Theadoptionofin‡ationtargetingbytheBankofKoreain1998wasanimportantfactorcontributingtoKorea’srecoveryfromthecrisisofthelate1990s.SoperhapsthedistinguishingcharacteristicoftherecentcrisisisitsimpactondevelopedeconomiessuchastheU.S.andthoseoftheEU,ratherthanthatitrepresentedanewphenomenon.1Thedecadepriortothecrisisrepresentedoneinwhichpolicymakersandacademiceconomistssharedabroadconsensusaboutmonetarypolicy(Svensson2002,Goodfriend2007).Amongthekeyaspectsofthisconsensusweretheroleofpricestabilityastheprimaryobjectiveofmonetarypolicyandtheimportanceofcentralbankcredibilityandtransparency.Mostdis-cussionsofmonetarypolicyemphasizedthedualobjectivesofstabilizingin‡ationaroundalowlevelandstabilizingsomemeasureofrealeconomicactivity.Financialstabilitywasalsomentionedasdesirable,butbyandlargediscussionsofmonetarypolicytook…nancialstabilityforgranted,andmodelsusedforpolicyanalysisalmostalwaysassumed…nancialfrictionswereirrelevantforpolicydesign.Mypurposeinthispaperistoconsiderhowthecrisishasin‡uencedourthinkingabouttwoaspectsofpolicy–instrumentsandobjectives–thatareintegraltothedesignandimplementationofmonetarypolicy.Insection2,Ifocusontheinstrumentsofmonetarypolicy.Duringthecrisis,centralbankshaverespondedwithtraditionalinterestratetools,beenforcedtodealwiththezerolowerboundonnominalinterestrates,andexpandedthescopeoftheirlenderoflastresortfunction.Inaddition,quantitativeeasingandcrediteasingpolicieshaveenteredthetoolkitofcentralbanks.Policyimplementationtypicallyisdependentontheparticular…nancialstructurewithineachcountry,so,giventhelimitstomyknowledge,thediscussionfocusesondevelopmentsintheU.S.Insection3Iturntotheoverallpolicyframework.Afterbrie‡yre-viewingtheperformanceofin‡ationtargeting,Iconsiderthreesuggestedmodi…cationstothispolicyframework.Theseareraisingtheaveragetargetforin‡ation,incorporatingadditionalobjectives,andswitchingtopriceleveltargeting.Conclusionsaresummarizedinthe…nalsection.2InstrumentsThelistofcentralbankinstrumentshasexpandedgreatlyoverthepastthreeyears.Traditionally,thislistwasquiteshort,consistingof,inthecaseoftheUnitedStates,openmarketoperations,thediscountrate,andthe1Forahistoricalreviewof…nancialcrises,seeReinhartandK.Rogo¤(2009).2requiredreserveratio.Asaconsequenceofthe…nancialcrisis,theFedatonepointlisted11di¤erentpolicytools(…veofthosehavenowexpired).ThesearchfornewtoolswasmotivatedbyadesiretoexpandtheFed’sroleasalenderoflastresorttoamuchwiderclassofinstitutionsandonamuchwiderrangeofcollateralthanpreviously,andbythefactthatthefederalfundsratehadbeencuttozero.Inthissection,I…rstfocusontheconventionaltoolsofmonetarypolicy,innormaltimesandattheZLB.IdiscusstheroleofpayinginterestonreservesintheFed’sstrategyforre-turningitsbalancesheettonormal.IthenturntothemoreunconventionalaspectsofrecentFedpolicy.2.1ConventionalToanalyzeconventionalmonetarypolicy,itisusefultospecifyaconven-tionalmodel.Thestandard,closedeconomynewKeynesianmodelthathasdominatedpolicyanalysisconsistsofanexpectationalISrelationshipgivenbyxt=Etxt+11(itEtt+1rnt),(1)andandin‡ationadjustmentequationgivenbyt=Ett+1+xt+et,(2)wherextistheoutputgap,tisin‡ation,rntistheequilibriumrealinterestratewhentheoutputgapiszero,etisacostshock,anditisthenominalinterestrate.Theseequationscanbederivedbylog-linearizingageneralequilibriummodelconsistingofarepresentativehouseholdand…rmsoperat-ingingoodsmarketscharacterizedbymonopolisticcompetitioninthefaceoftime-dependentpriceadjustmentstrategies.2Inthecontextofthismodel,theconventional