Tuesday, July 7, 2009

real and nominal interest rates and monetary policy

What does distinction between nominal and real interest rates means for monetary policy? It adds yet another uncertainty to the effect of monetary policy. In the AS\AD model we assumed that expansionary monetary policy lower the interest rate and contractionary monetary policy increases the interest rate. However, if the expansionary monetary policy leads to expectations of increased inflation, expansionary monetary policy can increase nominal interest rate (the ones you see) and leave real interest rates (the ones that affect borrowing decision) unchanged. Why? Because of expectations of increasing inflation. Lenders will want to be compensated for the inflation (which will decrease the value of the money they receive back) and will push the nominal interest rate up to get the desired real rate of interest.
The distinction between nominal and real interest rates and the possible effect of monetary policy on expectations of inflation as led most economists to conclude that a monetary regime, not a monetary policy, is the best approach to policy. A monetary regime is a predetermined statement of the policy that will be followed in various situations. A monetary policy, in contrast, is a response to events; it is chosen without a predeter mined framework.
Monetary regimes are now favored because rules can help generate the expectations that even though in certain instances the Fed in increasing the money supply, that increase is not a signal that monetary expansion and inflation are imminent. The monetary regime that the fed currently uses involves feedback rules that center on the federal funds rate. If inflation is above its target, the fed raises the federal funds rate (by selling bonds, thereby decreasing the money supply) in an attempt to slow inflation down. If inflation is below its target, and if the economy is going into a recession, the Fed lowers the fed funds rate (by buying bonds, there by increasing the money supply). The Taylor rule discussed above is a quantification of this general feedback rule.

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