Monetary policy I

Lecture handout: Monetary policy*

This lecture covers a lot of ground but tries to give you a relatively simple, usable framework to relate monetary economics to monetary policy decisions. One problem when studying macroeconomics is the belief that it equips us with an ability to forecast. See my video on Economic Prediction for why I think we need to be careful (and here is a short follow up quiz).

You may think that I am being harsh on economic forecasters. But I agree with Andy Haldane when he said, “It has been argued that these models were not designed to explain such extreme events. For me, this is not really a defence. Economics is important because of the social costs of extreme events. Economic policy matters precisely because of these events. If our models are silent about these events, this jeopardises the very thing that makes economics interesting and economic policy important.”

The key finding of monetary economics is that the root cause of inflation is excessive money creation. We looked at some specific examples of hyperinflation, and to learn more you can watch “Zimbabwe and Hyperinflation: Who Wants to Be a Trillionaire?” (Marginal Revolution University). The BBC has an article to show how you can calculate your own personal inflation rate (provided it’s 2015 and you live in the UK!).

Conventional monetary policy is a simple link between a target (usually inflation) and a tool (interest rates). During the lecture I implied that central bankers change interest rates relative to the current rate. In some cases, however, they may be trying to move the policy rate closer to some sort of benchmark. A common benchmark can be calculate using a Taylor Rule. For examples, see Kaleidic Economics.

The key goal for monetary authorities is credibility: [Credibility flashcard]

To get a feel for how central bankers should respond to changing conditions, try these simulators:

A corridor system is when the central bank targets three policy rates. We looked at how those rates changed from 2003-2015 in the Eurozone. The ECB website has more recent data.

The Dynamic AD-AS model is a really good way to think through macro events. If it is unclear after the Monetary and Fiscal policy lectures, there are plenty more resources on this page of my website.

The lecture also introduces the concept of the signal extraction problem. This isn’t the most intuitive concept to grasp, but it explains how nominal shocks can have real effects. In other words how changes in the money supply can affect inflation and real growth. A good article on this is Steve Horwitz’s ‘The Parable of the Broken Traffic Lights“.

What constitutes an optimal currency areas? [Optimal Currency Areas flashcard]

I also like the “Econ Talk” podcast, and the episodes with Milton Friedman on Money (August 28th 2006), Allan Meltzer on Inflation (Feb 23rd 2009), and Charles Calomiris on the Financial Crisis (Oct 26, 2009), are particularly relevant.

What is a yield curve:

This page ties into Chapter 8 of Economics: A Complete Guide for Business

Learning Objectives: Understand the root causes of inflation, and contribute to policy discussions. Understand how monetary policy affects business decision-making and thus generates macroeconomic fluctuations

Cutting edge theory: Nominal income targeting and surveying current monetary indicators. 

Focus on diversity: One of the most influential books on monetary economics was co-authored by Anna Schwartz. You can learn more about her here

Spotlight on sustainability: We look at how interest rates enable intertemporal coordination

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