Monetary Policy Rules

Question 1

What is a monetary policy rule?

Answer 1

Rules that central banks employ whose goal are to meet price stability

Question 2

The original Taylor Rule (Purpose, Critique)

Answer 2

Purpose:
Track federal funds rate in US (Especially 1987 -1992). It suggests that central banks should set short term interest rate based on economic conditional. It seeks to keep the economy operating close to its potential growth rate while maintaining price stability

Critique:
Lucas critique states that if central banks consistently apply the same strategies for certain situations, people and firms will recognize the patterns and act differently. Hence, it will not make sense to only look at historical data when applying policy rules since it does not take into account change in behaviour.

Question 3

What is Time-inconsistent monitary policy ?

Answer 3

The phenomenon of central banks changing their policy as a result of economic or political circumstances changes. This can lead to central banks loosing credability but it might still be tempting for central banks to operate this way considering the example of unemployment and inflation (expansory policy to lower unemployment even if it means higher inflation) not sustainable long term.

Question 4

Explain the variables in the Taylor rule ( r = p + 0,5y + 0,5(p - 2) + 2

Answer 4

r = federal fund rate
p = annual inflation
y = percent deviation of rela GDP from a target (output gap)

0,5 represents the target of central banks where one part is output gap stabilization and one part for inflation stabilisation.

2 represents the inflation goal of 2%