Expectations and commitment are monetary policy

I know we hear a lot about what “monetary policy is” in New Zealand.  According to our media monetary policy can make our incomes the same as those in Australia, make the price of everything move in our favour, build us new houses, reduce our reliance on foreign everything, increase and decrease house prices, and make us generally happier.

Now, as readers of TVHE you have seen past this rouse, and you recognise that monetary policy is independent cyclical policy that is intended to ensure that “inflation” stays at a certain rate and that shifts in output due to “aggregate demand” are kept to a minimum.  Again, this is a simplification – but it gives us our role, something we have discussed in more detail here. [BTW, there is a good post on discussing the right practical target variable here].

When thinking about what real inflation is we get to the point that “inflation” is very much driven by expectations.  As a result, the goal of the monetary authority is to anchor inflation expectations!  This is exactly the point made here, and it is true – Chuck Norris and the central bank have a lot in common.

When we understand this, we can get an idea of what to do when we are in a liquidity trap.  Simply put, say you are going to violate the target and target a higher level – or find a way to commit to it if needs be (thereby getting those real interest rates down – something that has been forgotten recently).  There is wide agreement among economists on this from the left and the right, and yet peoples refusal to look at monetary policy in this frame is stopping society from putting in place the correct monetary policy/framework.

However, we can also get an idea of the real issues in monetary policy – do we really understand how expectations are formed?  Do we really have a way of measuring commitment by a central bank?  Do we get commitment of the target, or of the institution, when we do this?  Even so, it is off this true base of understanding that we can analyse the issue – instead of the ad hoc and patently ridiculous things that are written about monetary authorities a lot of the time.

Note:  Good post here discussing monetary policy in terms of expectations and co-ordination – good links at the end as well.

  • philoff

    What’s your view on NGDP targeting?

    • http://www.tvhe.co.nz Matt Nolan

      I think targeting NGDP futures is very similar to targeting expected inflation.  However, there are a few costs and benefits.

      Benefit:

      Targeting the NGDP level provides more certainty about the price level and nominal activity in the future – giving certainty for investment.

      Cost:

      In the face of supply shocks, NGDP targeting leads to excessive loosening – keeping inflation at a higher level than is preferable.

      In New Zealand:

      In the New Zealand context, we are subject to constant supply shocks given our position as a small open economy – as a result, I feel the argument leans towards inflation targeting instead of NGDP targeting.