Bernanke explains Monetary Policy

Let me reiterate something I keep saying. Read all Bernanke speeches. It is a must.

In this speech (given in 2004) he explains what the monetary policy is. It is aptly titled ‘Logic of Monetary Policy’.

He begins by saying that framing US Mon Pol is not that simple as it is made out to be. He says people compare it wrongly to the car and Driver:

A commonly used analogy takes the U.S. economy to be an automobile, the FOMC to be the driver, and monetary policy actions to be taps on the accelerator or brake. According to this analogy, when the economy is running too slowly (say, unemployment is high and growth is below its potential rate), the FOMC increases pressure on the accelerator by lowering its target for the federal funds rate, thereby stimulating aggregate spending and economic activity. When the economy is running too quickly (say, inflation appears likely to rise), the FOMC switches to the brake by raising its funds rate target, thereby depressing spending and cooling the economy. What could be simpler than that?

BB says this analogy is wrong for two reasons:

1) Unlike a car driver, the policymakers face informational constraints and the economic data available does not cover the entire economy and is available with a lag. In BB’s words:

In short, if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake. 🙂

2) Monetary Policy uses Fed Funds Rate (FFR) as a tool to monitor interest rates and FFR is not as effective as accelerator or brake.

The current funds rate imperfectly measures policy stimulus because the most important economic decisions, such as a family’s decision to buy a new home or a firm’s decision to acquire new capital goods, depend much more on longer-term interest rates, such as mortgage rates and corporate bond rates, than on the federal funds rate. Long-term rates, in turn, depend primarily not on the current funds rate but on how financial market participants expect the funds rate and other short-term rates to evolve over time…..

……In short, if the economy is like a car, then it is a car whose speed at a particular moment depends not on the pressure on the accelerator at that moment but rather on the expected average pressure on the accelerator over the rest of the trip–not a vehicle for inexperienced drivers, I should think.

How does he explain monetary policy so easily? I wonder who his students are?

BB explains there are 2 mon pol frameworks- instrument policy and targeting policy (they are generally called instrument rules and targeting rules but rules means a strict regimen is not accepted anymore in academia and policymaking; hence rules have been replaced by policy).

1) Instrument policy is a simple feedback policy. Taylor’s rule is the best example of instrument policy. In BB’s words:

Under a simple feedback policy, the central bank’s policy instrument–the federal funds rate in the United States–is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy’s full-employment level of output).

Its advantage is it is very simple and easy to understand for the public

2) The second approach is based on forecasts and here policymakers must have a view on the course the economy is likely to take in say next six to eight quarters and accordingly make a policy.

So forecast based policies need much more information than the feedback model and this is the drawback most followers of first point out to. In response, forecasters say policymakers should use the available information and should be humble about their abilities to forecast. As long as Central Banks communicate properly about forecasts and their outlook, the model should work fine.

BB does not say which is the best approach and says debates are lively in this area. However, what supports forecast proponents is that most Central Banks are leaning towards forecast-based models . He cites evidence from Greenspan’s speech that even FOMC (US Mon Pol committe) prefers forecast based models.

RBI also follows more of a forecast based approach and give their views on economy and monetary policy in their quarterly meetings (next to be held on July 31).  I am not sure about their communication strategy though. It is not as transparent as market participants would like it to be.

Keep educating is Sir!

One Response to “Bernanke explains Monetary Policy”

  1. Traffic management and financial crisis « Mostly Economics Says:

    […] is Bernanke explaining monetary policy and Jeff Frankel explaining financial globalization using very similar […]

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