Marvin Goodfriend

Interest Rates and the Conduct of Monetary Policy

The paper describes key aspects of actual Federal Reserve interest rate targeting procedures and addresses a number of issues in light of these stylized facts. It reviews the connection between rate smoothing and price level trend-stationarity. It critiques interest rate targeting as inflation tax smoothing. It argues that stabilization policy implemented by interest rate targeting may inadvertently induce martingale-like behavior in nominal rates and inflation. The paper explains why central bankers prefer continuity of the short rate and indirect rate targeting. Lastly, it surveys empirical evidence of the Feds influence over short-term interest rates.

Financial deregulation, monetary policy, and central banking

The paper analyzes the need for financial regulations in the implementation of central bank policy. It emphasizes that a central bank serves two functions. Central banks function as monetary authorities, managing high-powered money to influence the price level and real activity; and they engage in regular and emergency lending to financial institutions. The authors term these functions monetary and banking policies, respectively. They emphasize that regulations are not essential for the execution of monetary policy because high-powered money can be managed with open market operations in government bonds. By its very nature, however, banking policy involves a swap of government securities for claims on individual banks. Just as private lenders must restrict and monitor individual borrowers, a central bank must regulate and supervise the institutions that borrow from it. Virtually all economists agree that there is an important role for monetary policy to stabilize prices and real activity. Banking policy has been rationalized as a source of funds for temporarily illiquid but solvent banks. To assess that rationale, the authors develop the distinction between illiquidity and insolvency in detail, showing the distinction to be meaningful precisely because information about the value of bank assets is incomplete and costly to obtain. Nevertheless, they explain why the cost of information per se cannot rationalize banking policy. On the basis of such considerations, they find it difficult to make a case for banking policy and the regulatory and supervisory activities that support it.

Overcoming the Zero Bound on Interest Rate Policy

The paper proposes three options for overcoming the zero bound on interest rate policy: a carry tax on money, open market operations in long bonds, and monetary transfers. A variable carry tax on electronic bank reserves could enable a central bank to target negative nominal interest rates. A carry tax could be imposed on currency to create more leeway to make interest rates negative. Quantitative policy--monetary transfers and open market purchases of long bonds--could stimulate the economy by creating liquidity broadly defined. A central bank needs more fiscal support than usual from the Treasury to pursue quantitative policy at the interest rate floor.

The Case for Price Stability

Reasoning within the New Neoclassical Synthesis (NNS) we previously recommended that price stability should be the primary objective of monetary policy. We called this a neutral policy because it keeps output at its potential, defined as the outcome of an imperfectly competitive real business cycle model with a constant markup of price over marginal cost. We explore the foundations of neutral policy more fully in this paper. Using the principles of public finance, we derive conditions under which markup constancy is optimal monetary policy. Price stability as the primary policy objective has been criticized on a number of grounds which we evaluate in this paper. We show that observed inflation persistence in U.S. time series is consistent with the absence of structural inflation stickiness as is the case in the benchmark NNS economy. We consider reasons why monetary policy might depart from markup constancy and price stability, but we argue that optimal departures are likely to be minor. Finally, we argue that the presence of nominal wage stickiness in labor markets does not undermine the case for neutral policy and price stability.

Interest rate smoothing and price level trend-stationarity

For industrial countries in the post-war period, the price level and the money stock have displayed little tendency to revert to given growth paths. Indeed, this stylized fact is frequently referred to by monetarist critics of central banks, who point out that periods of temporarily high or low money growth, rather than being subsequently reversed, typically alter the level of money stock and prices permanently.

Demand for Money: Theoretical Studies

In any discussion of the demand for money it is important to be clear about the concept of money that is being utilized; otherwise, misunderstandings can arise because of the various possible meanings that readers could have in mind. Here the term will be taken to refer to an economy’s medium of exchange: that is, to a tangible asset that is generally accepted in payment for any commodity. Money thus conceived will also serve as a store of value, of course, but may be of minor importance to the economy in that capacity. The monetary asset will usually also serve as the economy’s medium of account — that is, prices will be quoted in terms of money — since additional accounting costs would be incurred if the unit of account were a quantity of some asset other than money. The medium-of-account role is, however, not logically tied to the medium of exchange (Wicksell, 1906; Niehans, 1978).

Reinterpreting money demand regressions

It has been two decades since a partial adjustment model was first applied in empirical money demand studies. Since then the partial adjustment specification has become widely used, particularly in quarterly money demand studies. However, the theoretical rationalization for partial adjustment has never been entirely satisfactory. Furthermore, a number of empirical characteristics of the conventional money demand regression have proven difficult to interpret under the partial adjustment specification. This paper offers an alternative interpretation of the conventional money demand regression results, one that does not rely on a partial adjustment rationale. Instead, money demand is assumed to adjust completely each period to current interest rate and transaction variables. But empirical measures of these regressors are contaminated by stochastic measurement error. This interpretation is able to explain many characteristics of the conventional money demand regression that have proven difficult to interpret from a partial adjustment point of view. A conventional money demand regression with a partial adjustment specification is described in Section II. Following this description, a number of specific difficulties in interpreting the conventional money demand regression are detailed. Theoretical weaknesses with the partial adjustment rationalization and difficulties with the partial adjustment interpretation of specific empirical characteristics of the conventional money demand regression are discussed. In Section III, coefficients in a

Monetary Policy in the New Neoclassical Synthesis: A Primer

This primer provides an understanding of the mechanics and objectives of monetary policy using a benchmark new neoclassical synthesis (NNS) macromodel. The NNS model incorporates classical features such as a real business cycle (RBC) core, and Keynesian features such as monopolistically competitive firms and costly price adjustment. Price stability maximizes welfare in the benchmark NNS model because it keeps output at its potential defined as the outcome of an imperfectly competitive RBC model with a constant markup of price over marginal cost.

Information-aggregation bias

Aggregation in the presence of data processing lags distorts the information content of data, violating orthogonality restrictions that hold at the individual level. Though the phenomenon is general, it is illustrated here for the life cycle-permanent model. Cross-section and pooled-panel data induce information-aggregation bias akin to that in aggregate time series. Calculations show that information-aggregation can seriously bias tests of the life cycle model on aggregate time series, cross-section, and pooled-panel data.

Financial stability, deflation, and monetary policy

The paper explores the relationship between financial stability, deflation, and monetary policy. A discussion of narrow liquidity, broad liquidity, market liquidity, and financial distress provides the foundation for the analysis. There are two preliminary conclusions. Equity prices are a misleading guide for interest rate policy. Monetary policy tactics protect market liquidity while maximizing the central banks leverage over longer-term interest rates and aggregate demand. Monetary policy is a fundamental source of deflation and stagnation risk when price stability is fully credible. A central bank can be fooled by its own credibility for low inflation into being insufficiently preemptive in a business expansion. Then monetary policy can be constrained by the zero bound from reducing real interest rates enough in the subsequent contraction. The chain of events that leads to deflation and stagnation can be weakened or broken in a number of places. Monetary policy has the power to preempt deflation and the power to overcome the zero bound to restore prosperity after a deflationary shock. Fiscal policy is likely to be relatively ineffective at best and counterproductive at worst.