Page 354 - Krugmans Economics for AP Text Book_Neat

Panel (c) of Figure 31.4 compares the federal funds rate specified by the Taylor rule
with the actual federal funds rate from 1985 to 2009. With the exception of 2009, the
Taylor rule does a pretty good job at predicting the Fed’s actual behavior—better than
looking at either the output gap alone or the inflation rate alone. Furthermore, the di-
rection of changes in interest rates predicted by an application of the Taylor rule to
monetary policy and the direction of changes in actual interest rates have always been
the same—further evidence that the Fed is using some form of the Taylor rule to set
monetary policy. But, what happened in 2009? A combination of low inflation and a
large and negative output gap briefly put the Taylor’s rule of prediction of the federal
funds into negative territory. But a negative federal funds rate is, of course, impossible.
Courtesy of John Taylor to almost zero.
So the Fed did the best it could—it cut rates aggressively and the federal funds rate fell
Monetary policy, rather than fiscal policy, is the main tool of stabilization policy.
Like fiscal policy, it is subject to lags: it takes time for the Fed to recognize economic
problems and time for monetary policy to affect the economy. However, since the
Stanford economist John Taylor sug- Fed moves much more quickly than Congress, monetary policy is typically the pre-
gested a simple rule for monetary policy.
ferred tool.

Inflation Targeting
The Federal Reserve tries to keep inflation low but positive. The Fed does not, however,
explicitly commit itself to achieving any particular rate of inflation, although it is
widely believed to prefer inflation at around 2% per year.
By contrast, a number of other central banks do have explicit inflation targets. So
rather than using the Taylor rule to set monetary policy, they instead announce the in-
flation rate that they want to achieve—the inflation target—and set policy in an attempt
to hit that target. This method of setting monetary policy is called inflation targeting.
The central bank of New Zealand, which was the first country to adopt inflation tar-
geting, specified a range for that target of 1% to 3%. Other central banks commit them-
selves to achieving a specific number. For example, the Bank of England is supposed to
keep inflation at 2%. In practice, there doesn’t seem to be much difference between
these versions: central banks with a target range for inflation seem to aim for the mid-
dle of that range, and central banks with a fixed target tend to give themselves consid-
erable wiggle room.
One major difference between inflation targeting and the Taylor rule is that infla-
tion targeting is forward -looking rather than backward -looking. That is, the Taylor
rule adjusts monetary policy in response to past inflation, but inflation targeting is
based on a forecast of future inflation.
Advocates of inflation targeting argue that it has two key advantages, transparency
and accountability. First, economic uncertainty is reduced because the public knows the
objective of an inflation -targeting central bank. Second, the central bank’s success can
be judged by seeing how closely actual inflation rates have matched the inflation tar-
get, making central bankers accountable.
Critics of inflation targeting argue that it’s too restrictive because there are times
when other concerns—like the stability of the financial system—should take priority
over achieving any particular inflation rate. Indeed, in late 2007 and early 2008 the Fed
cut interest rates much more than either the Taylor rule or inflation targeting would
have dictated because it feared that turmoil in the financial markets would lead to a
major recession (which it did, in fact).
Many American macroeconomists have had positive things to say about inflation
targeting—including Ben Bernanke, the current chair of the Federal Reserve. At the
Inflation targeting occurs when the central
bank sets an explicit target for the inflation time of this writing, however, there were no moves to have the Fed adopt an explicit in-
rate and sets monetary policy in order to hit flation target, and during normal times it still appears to set monetary policy by apply-
that target. ing a loosely defined version of the Taylor rule.

312 section 6 Inflation, Unemployment, and Stabilization Policies