ultimate objectives of monetary policy

ultimate objectives of monetary policy, that the Federal reserve most strongly pursues when it formulate its monetary policies.
Achieving high and stable output levels
One key goal of the Fed is to lay the best monetary policy foundation for the nation to attain high and stable levels of production of goods and services. A nation that produces more output per person than other nations is often assumed more likely to have happier and more productive citizens. A nation that can achieve higher and more stable growth in its production of real output also has better foundation for long-run prosperity for its citizens.
The economy‘s aggregate production function indicates that if real output is high, labor unemployment rates are low, holding other factors unchanged. For this reason, an ultimate aim by The Federal Reserve to attain high and stable growth of real output essentially is the same as a goal to achieve low and stable unemployment rates.
Maintaining low inflation and stable prices
the second fundamental goal of the Fed is to achieve low and stable inflation rates. High inflation, in the absence of fully indexed nominal contracts, imposes a variety of potential costs on individuals, firms, and financial institutions. For one thing , greater inflation encourages individuals and firms to find ways to economize on their holdings of currency and demand deposits , which entails expenditures of real resources. It also entails more frequent price changes and associated menu costs . individuals and firms may also be induced to change the terms of wage and other contracts much more frequently, which is costly in time and effort, or to index contracts to inflation to a larger extent, which also may entail resources costs.
Unanticipated inflation also has redistribution effects, because it effectively transfers wealth from creditors to debtors. Another possible redistribution effect arises if income taxes are not fully indexed, because inflation increases nominal incomes and thereby pushes people and firms into higher tax brackets, effectively raising their taxes without any actual income tax rate increases. to the extent that individuals and firms seek to avoid such redistribution effects, they also incur direct real costs.
Finally, inflation variability also may be costly, because it forces economic agents to determine whether aggregate or relative prices have changed, thereby complicating consumption and production decisions.

Discretionary Monetary policy and inflation

many economist find Friedmanُ s argument persuasive. Nevertheless, most believe that the fed conducts discretionary monetary policies. Indeed, economists at the fed-a few of whom even had Milton Friedman as a professor in years past- commonly defend fed discretion, arguing that fed has done much to reduce the durations of the various time lags. If the time lag problem is , or has been, solved , they contend, discretion is preferable to fixed policy rules.
In light of Friedman‘s model that we discussed above, this view has its merits. if the Fed could always learn quickly about the need for a policy action and respond quickly to that need, it might be able to conduct truly countercylical monetary policies.
It turn out, however, that there is another potential problem with discretionary policy making by the fed. As we explain below, monetary policy discretion may contribute to inflation. That is, a discretionary monetary policy maker may adopt inflationary policies that wanted result from a lack of a monetary policy rule. Furthermore, this could happen even if the fed does not want high inflation.Hence, rules still may be better than discretion.

effect of uncertain inflation on debt maturity

Since inflation is generally harder to predict, the longer the period over which the prediction is made, uncertainty about inflation often leads to a reduction in the length of time over which nonindexed agreements are made. Thus the average maturity of debt issued in periods of great inflationary uncertainty is usually less than in more stable times. in some cases this can be mitigated by creative financing. key examples are " floating rate" loans, mortgages, and bonds, which provide medium-to long -term debt at short-term rates. Interest payments are allowed to vary, with each one determined by adding a fixed differential (e.g.,1%)to a specified base, such as the " prime rate" or the yield on a 90-day U.S. Treasury bill in the prior period. If short-term interest rates anticipate inflation reasonably well, such a security is at least a partial substitute for a fully indexed bond.
inflation, if allowed to run rampant, with great uncertainty about the actual level, can threaten the entire structure of a monetary economy, and with it the whole financial sector. On the other hand, it can be controlled within limits, and financial instruments can be designed to avoid some of its serious side-effects.

the impact of unexpected inflation on the price of a common stock

A company is financial statements can be used to obtain a rough estimate of the impact of a divergence between actual and expected inflation on the value of the firm is common stock. Each item can be classified as either a real, short-term monetary, or long- term monetary asset or liability. in some cases the classification is fairly obvious; in others it is some-what arbitrary. However, detailed Knowledge of a company and\or sumer price index in recent years, but there is probably more to it than this.
One cannot help be struck with the fact that those who invested in short-term securities over this period frequently ended up with less purchasing power than they started with: real return was negative in 23 of the 53 years. perhaps even more surprising, the average real return over the period was zero!
while expected real returns may vary from year to year, the variation may be relatively small. if so, investors may well have been willing to invest in short-term highly liquid securities even though they expected to earn nothing at all in real terms. if they are willing to do so still, such securities will be priced to give an expected real return of approximately zero.
if this assumption is made, the "market’s" predicted rate of inflation over the near future can be estimated by simply looking at the current annual yield on short-term government securities. In a sense, Treasury bill yields represent a consensus prediction of inflation-a prediction likely to be more accurate in many cases than the predictions of any single forecaster.

why Bother About inflation ? (7)

we can sum up by saying that inflation needs to be prevented because it redistributes income ans wealth in arbitrary and potentially unjust way; because it complicates the task of the individual who wishes to smooth out his lifetime patterns of consumption and income; because it is a potential source of difficulty in the balance of payments ; because it imposes a variety of real costs both on individuals and on firm; and because it distorts the basic institutions of modern capitalist society.
some economists argue that these troubles would not be serious if inflation were steady and if exchange rates were flexible. For if the inflation rate were to settle at, say, a steady 5 per cent annum , year-in-year-out,an annual 5 per cent inflation rate would come to be generally expected, "interest rates would ultimately reflect the pace of inflation; salaries and other sticky incomes and the entire institutional framework would be increasingly adjusted, that is the bad redistributive effects of inflation would disappear. and if exchange rates were flexible, the ill effects on the balance of payments of more rapid inflation than in the rest of the world could always be nullified by an appropriate adjustment of the exchange rate.

why Bother About inflation ? (6)

A final reason for rejecting inflation is that it distorts the institutions which lie at the heart of modern capitalist society. Once again it is hard to improve on Hick is treatment . He says :
The habits- business habits as well as personal habits- which are based on the assumption of stable prices are too strong to be easily broken. Nor is it just habits... it is also institutions. The accounting system, the tax system, even the general legal system, all are based on the assumption of stable value of money ; if the value of money is seriously changeable, they are twisted out of shape. The accountant is "profits" cease to be true profits; the taxes that are imposed are different to what was intended; the fines and penalties imposed by the courts, as well as the compensations which they award, lose their proper effect. now it is of course true that these things can be put right (for a time) by legislation; but only by re-opening issues that had been taken to be closed. There is waste of time in re-discussing them-surely a much more serious waste of time and energy than is involved in holding "too small" money balance.

why Bother About inflation ? (5)

A fifth reason for rejecting inflation, Which is closely related to the one just discussed has been well expressed by Hicks in the following way:
If one examines the balance-sheet of the business "at a moment of time" it will usually be found to have among its assets not only some money which is not earning interest, but also some debts owing to it on which it is not charging interest. If one asks why it should hold assets in this latter from, the answer is surely that it is a matter of convenience, Just like the reason for holding money. A debt that is due from a regular customer is not regarded in isolation; it is part of the regular relation between customer and supplier, which it is to the interest of both to maintain in way that is convenient to both. On This, as on the money holding, inflation exercises a pressure. when money rates of interest are high.... the loss of interest that is involved in unpaid debts becomes more serious. It thus becomes profitable to take more trouble in collecting debts promptly, exerting pressure on debtors which would otherwise not need to be exerted. There is a real loss, measurable in lab our-time, in exerting such pressure. And since the debtor himself has a similar incentive to delay payments, it is easily intelligible that the loss can be considerable.

why Bother About inflation ? (4)

we turn now to a fourth reason for thinking that inflation should be prevented. When the general price level rises the real value of a given sum of money decline. For example if the price level rises by 10 per cent between the beginning and the end of a particular year, a sum of $100 expressed in beginning-of-year prices will be $100\1.1 at the end of the years as compared with $100 at the beginning of the year. That is, the real value of $100 will decline by a little over 9 per cent in the course of the year. Because of this fact, wealth-holders have a strong incentive, under inflationary conditions, to keep as a little of their wealth as possible in the from of money and as much as possible in the from of assets whose price rises at least as rapidly as the general price level, and which, therefore, do not decline in real terms. This means, in turn, that both individuals and firms face if prices were stable. first, there is the time and effort (physical and mental) which they put into the task of economizing on money balance; then there is the inconvenience associated with liquidity which they suffer if they are successful in this task. If the rate of inflation is moderate-say less than 5 per cent per annum - these real costs will probably not matter very much. however, once the inflation rate climbs to something like 15-20 per cent per annum they can no longer be ignored. And in extreme inflation,when the loss of real wealth consequent on holding money become a major consideration and people seek to pass on money as quickly as possible after receiving it, the real costs in question are undoubtedly very large indeed.

why Bother About inflation ? (3)

A third reason why most governments are anxious nowadays to avoid inflation is that it may lead to balance-of-payments difficulties.This, of course, is an especially important consideration for countries like the United kingdom, where foreign trade plays a major role in the economy inflation can weaken the balance of payments both by stimulating imports and by restricting exports. Imports will be stimulated because when the price of the domestic product rises, the foreign product becomes more attractive to the domestic purchaser, other things remaining the same, than was previously the case. On the other hand, the growth of exports will be checked by rising domestic costs and prices because, ceteris paribus, rising costs weaken the competitive position of domestic producers in foreign markets.
Of course, if the costs and prices of foreign producers are also rising,along with those of domestic producers, the consequences of inflation for the balance of payments will be less serious than if the costs of foreign producers are stable or falling. For, in the former case, the competitive position of foreign producers in the home market will be strengthened less, and the competitive position of domestic producers in the foreign markets weakened less, by inflation than in the latter case. Thus from the point of view of the balance of payments it is not inflation as such which is undesirable but rather more rapid inflation than in the rest of the world.

why Bother About inflation ? (2)

A second reason for regarding inflation as undesirable is that it face a person who wishes to save in order to provide an income for his old age, or to educate his children, or to build a house, with avery serious dilemma. IF he invests his savings in life-assurance policy or in government bonds, or if he place them with a bank on fixed deposit, he can be sure that on certain dates in the future certain fixed sums of money will be forthcoming. But he takes the risk that inflation will reduce the real value of these sums to such an extent that he will find it impossible to meet the needs for which the savings have been made. On the other hand, if he invents his savings in some from of real property he avoids the inflation risk because it is reasonably certain that property values will rise at least as rapidly as the general price level. But he lacks the assurance that certain fixed sums of money will become available to him at certain Specified dates in the future because, while the value of property in general is likely to rise with the general price level, the value of his property may well fall, for example because of the establishment of some source of noise, or other pollution in the vicinity, or because bridge connecting the suburb in which his property is located with the rest of the city collapses. This is the dilemma referred to earlier; and the fact that inflation faces the ordinary, prudent individual with a choice between such unpleasant alternatives is strong argument for trying to prevent it.

why Bother About inflation ?

perhaps the main reason for trying to prevent the persistent upward movement in the general price level, which constitutes inflation according to our definition, is that it leads to a redistribution of real income which is arbitrary and which, therefore, may well be socially unjust. people whose money income rises less rapidly than the general price level will lose relatively in times of inflation, while those whose money income rises more rapidly than the price level will again. The losers will probably include pensioners, people whose main source of income is interest or rent, professional people such as lawyers, doctors and academics and the producers of some primary products sold on world markets. the gainers will include other primary producers, strongly organized wage-earners and businessman. while some of this redistribution may be socially desirable, it is clear that much of it will not be.
The redistributive effects of inflation are not confined to real income; they extend also to real wealth. people or institutions whose wealth is comprised mainly of assets with a fixed, or virtually fixed, money value, such as bank deposits, government bonds and private debt of various kinds, will lose relatively in terms of wealth under inflationary conditions. persons whose assets consist mainly of real property or whose liabilities remain fixed in money terms will gain relatively. Once again, while some of this redistribution may be in a socially desirable direction, much of it will not be.

the implicit deflator of GNP

The implicit deflator of G.N.P. is not a price index in the ordinary sense,and,before attempting to assess its suitability for the purpose of measuring inflation,it may be desirable to explain the way in which it is calculated. The implicit deflator of G.N.P., SAY for any quarter,is obtained by dividing the G.N.P.for the quarter in terms of current prices by the G.N.P.for the quarter in terms of constant prices. For example,Australia,s G.N.P.for the September quarter 1968 was $6446 million in current prices and $6133 million at average 1966-7 prices. Hence the implicit deflator of G.N.P.for this quarter was 1.051 (=6446/6133)on the base 1966-7=1.
It will be clear from this explanation that,while the implicit deflator of G.N.P.is not a genuine price index,it can be interpreted in the same way as a price index.
Specifically,it can be thought of as a price index relating to all goods and services comprising G.N.P., that is to all goods and services produced within Australia.For example, Australia,s implicit deflator for the September quarter 1968(1.051)can be interpreted as indicating that the prices of all goods and services produced within Australia was a little over 5 per cent higher,in this quarter,than the average level for 1966-7.
Since the implicit deflator is,in effect,a price index relating to the goods and services comprising G.N.P.,it clearly stands up well on the first two of our four requirements;it relates only to goods and services produced within Australia and it relates to all such goods and services. On the other hand, it is rather unsatisfactory from the point of view of the third and fourth requirements. Let us take them in turn.
From the explanation, given earlier,of the way in which the implicit deflator is calculated for any period,it is apparent that a critical element in the calculation is the estimate of G.N.P. at constant prices for the period. In the Australian case this estimate is obtained by making estimates of G.N.P.at constant prices,exports at constant prices and imports at constant prices and then using the identity: G.N.P.at constant prices= G.N.E. at constant prices plus exports at constant prices less imports at constant prices. Thus whether or not the deflator makes proper allowance for quality improvements (third requirement)depends,in the end,on whether or not there is due allowance for quality improvement in the constant-price estimate of G.N.E., exports and imports. In particular it depends on whether there is proper allowance for quality improvement in the constant-price estimate of G.N.E. is the dominant element in the right-hand side of the G.N.P. indentity. If inadequate allowance is made for quality improvement in the constant-price estimate of G.N.E.,the figure for G.N.P.at constant prices will tend to be too low and the figure for the implicit deflator too high. For example,in revaluing the X motor-cars purchased in year t in terms of the prices ruling in some base year (this would be part of the job of making the constant-price estimate of G.N.E.for one year t)one would have to recognise that the number of "base-year"motor-cars purchased in year t was really more than x because the year t motor-car was of better quality than the base-year motor-car.If one failed to take the quality improvement into account, one,s estimate of expenditure on motor-cars in year t in terms of base-year prices would be too low,and,to this extent,one,s figure for the implicit G.N.P. deflator for tear t would be too high.
To determine whether in fact due allowance is made for quality improvement in the Australian constant-price estimates of G.N.E. one must examine the procedures which the statistician uses to make these estimates. If this is done one is forced to the conclusion that,through no fault of his own, the statistician makes a quite inadequate allowance for quality improvement in his constant-price estimate of G.N.E.,and hence that this estimate understates the true constant-price figure,and in tum that the implicit deflator of G.N.P.overstates the extent of the rise in the general price level over any specified time period.
The implicit deflator of G.N.P. falls down,then,in relation to the third of our four requirements. Nor is it satisfactory in terms of the fourth requirement. The main reson is that since G.N.P.includes the value of production of the Australian farm sector as well as the value of production of the non-farm sector,the figure for G.N.P.in current prices for any quarter,say,will reflect price increases caused by production difficulties of a temporary kind in the farm sector. And since the G.N.P. deflator for any quarter is obtained simply by dividing the figure for G.N.P.in current prices by the figure for G.N.P. in constant prices,the deflator must also reflect the temporary price increases,contrary to the fourth of our requirements for an ideal index. A second reason why the implicit G.N.P.deflator is unsatisfactory in terms of the fourth requirement is that,since G.N.P. measures the value of production in the Australian economy as a whole in terms of market prices,the figure for G.N.P.in current prices will reflect price increases caused by the imposition or stiffening of indirect taxes or the removal of subsidies. Hence the implicit deflator of G.N.P. will reflect these price increases also,contrary to the fourth requirement for an ideal index once again.

the W.P.I.S or some component

The C.P.I. and its component indexes are retail price indexes. As alternatives for the purpose of measuring inflation, one could consider one of the two wholesale price indexes (the index of materials used in house-building, or the index of materials used in building other than house-building), or possible one of the component indexes from which the W.P.I.S are constructed. However,all of these indexes fall far below the ideal in relation to the second requirement since even the most comprehensive of them is restricted to some class of building materials.
In addition, since they all cover imported, as well as locally produced building materials, they are less than ideal from the standpoint of the first requirement.

the consumer price index (c.p.I)

while the c.p.i stands up reasonably well in relation to the third requirement, it appears to fall well short of the ideal when considered in relation to the first two and the last. Many imported goods are included in the C.P.I regimen. Also,since the index is intended to measure only variations in the retail prices of those goods and services which attract a substantial proportion of the aggregate expenditure of wage-earner, it is far from comprehensive. finally, the index covers all important raw foods and all commodities whose whose prices are subject to significant variation through fiscal action, as is only to be expected given the purpose for which it is designed. as a result the index is by no means unaffected by the type of temporary price increase that we exclude in our definition of inflation.

costs of reducing inflation

When policymakers are more concerned with maintaining high levels of output and employment growth than with maintaining a low inflation rate, they may exert an inflationary bias on monetary policy. (Another possibility-not considered here- is that the fed may incorrectly estimate the growth rate of velocity over long periods of time, allowing an inflationary money supply growth.) Suppose that, whatever the cause, policymakers decide at some point that the economy is sustained inflation rate is too high. How to achieve disinflation (a decline in the long-run rate of inflation) and whether there are costs to the economy from reducing inflation are viewed differently in the new classical and new Keynesian approaches.

full employment targets and inflationary basic

low inflation may be desirable, but it also brigs significant social costs, in terms of lost output and jobs when the economy is not operating at or near full capacity. Angry voters pressure elected officials to do something when recessions idle factories and swell unemployment lines.
the full employment act 1946 and the Humphrey-Hawkins Act of 1978 committed the federal government to promoting full employment and a stable price level. particularly during the 1960s and 1970s, U.S. policymakers often pressed for full employment even at the expense of inflation. two types of inflationary pressures resulted:cost-push inflation , which results from workers‘ pressure for higher wages; and demand-pull inflation,which results from policymakers‘ attempts to increase aggregate demand for current output above the full employment level .

expected inflation rate

Uncertainty about the rate of inflation can introduce the most serious costs of inflation. In a market economy, households and businesses look to prices of goods and assets as signals for resource allocation. For example, an increase in the price of beef relative to chicken encourages farmers to produce more beef and individuals to consume more chicken. An increase in stock market prices relative to the general level of prices is a signal that businesses, prospects are good and that there are opportunities for profitable investment. Relative prices, not individual prices,provide these signals.When inflation fluctuates significantly,relative prices may change in response to general price-level changes, distorting the valuable signals provided by markets. Variations of relative prices because of uncertain inflation cause households and businesses to waste resources investigating price differences.
An extreme case of uncertain inflation occurs in a "hyperinflation,in which the rate of inflation is hundreds or thousands or more percentage points per year for a significant period of time. The costs of hyperinflation are extremely high. Households and businesses must minimize currency holdings,and firms must pay employees frequently. Employees must spend money quickly or convert it to more stable foreign currencies before prices increase further.
A classic example of hyperinflation occurred in Germany after World War I. A burst of money creation by the government ignited inflation,increasing the price level by a factor of more than 10 billion between August 1922 and November 1923. For example, if a candy bar cost the equivalent of 5 cents in August 1922,this increase in the price level would have raised its cost to more than $500,000,000 by November 1923. Our analysis of money balances should plummet. In Germany that proved to be the case; By October 1923,real money balances had shrunk to only about 3% of their August 1922 value. The German hyperinflation ended suddenly in late 1923,with a strong government commitment to stop the printing presses. With a significant decline in growth of the money supply, hyperinflation ended.
Confusing signals from prices are particularly problematic during hyperinflation. With overall prices riding very rapidly,merchants change prices as often as possible. Prices therefore quickly fail to indicate value or direct resource allocation. The government,s tax-collecting ability diminishes significantly during hyperinflation. Because tax bills typically are fixed in nominal terms, households and businesses have a major incentive to delay payment of taxes in order to reduce their real tax burdens.

why policymakers allow inflation to occur

Despite the fact that inflation can generate tremendous costs for the economy, in order to achieve other goals (such as full employment of the economy is resources), governments sometimes pursue inflationary monetary policies . In particular, measures related to current output (such as the levels of GDP,households incomes, and the unemployment rate) capture the attention of voters and public officials alike. Indeed, movements in current output can greatly influence presidential elections, creating a temptation on increase aggregate demand in the short run.Ray Fair of Yale University has noted that significant GDP growth and a falling unemployment rate increased the reelection chances of incumbent president and other candidates of the same party.

Unexpected inflation

Many contracts in labor,goods and financial markets are written in nominal terms, cover a substantial period of time, and take expected inflation into account. However, unexpected inflation, or the difference between actual and expected inflation, redistributes wealth. for example, Suppose that a borrower and lender expect no inflation and agree to a one-year,$1000 loan at 4% interest. Regardless of the inflation rate for the year, the lender receives ($1000)(1.04)=$1040 from the borrower at the end of the year. If the actual rate of inflation is 7%, the lender is real return (the return in terms of purchasing power) is- 3%.Conversely, the borrower is real interest rate is -3%. the unexpected inflation of 7% (7%-0%)effectively transferred $70 of real purchasing power from the lender to the borrower. Another example of this redistribution occurs when unexpected inflation reduces real wages for employees with nominal wage contracts.
the implications of unexpected inflation are more difficult to gauge than those of expected inflation for the macro economy. Losses to some parties are matched by gains to others. Nonetheless, for individuals that are risk-averse, the possibility of redistribution can distort behavior.For example, amounts that businesses or households spend on forecasting inflation in order to protect themselves against unfavorable redistributions represent a cost of unexpected inflation.

expected inflation rate and financial decisions

expected inflation can effect the allocation of the economy is resources in three ways. First, inflation places a tax on money balances when those balances pay less than the market rate of interest. This tax is loss in purchasing power. For example, If you held $100 in currency in 1992 when the rate of inflation was about 3%, you lost $3 of purchasing power over the year. By imposing a tax on money balances, inflation reduces the public is demand for real money balances. One cost of this tax, known as shoe leather costs, is the cost to consumers and business of making more trips to the bank to avoid holding significant amounts of currency or of shifting fund from interest-bearing assets into money. when the public is shoe lather costs exceed the government is revenue gain from the inflation tax, inflation generates an "excess burden," or social loss. Stanley Fischer of M.I.T. has estimated that the annual excess burden in the UNITED STATES of a modest inflation rate of 5% is approximately 0.3% of GDP, or about $18 billion in 1992 dollars.
A second cost of expected inflation arises because the u.s. Tax system is defined in nominal terms. This definition means that the individual income tax is progressive and not fully indexed against inflation. AS a result, higher nominal incomes (for constant real incomes) can lead to a higher tax burden relative to income. this problem, called bracket creep, was particularly severe in the 1970s, when the individual income tax was more progressive than it is in the early 1990s. the failure of the tax code to adjust values of inventories and the value of depreciation allowances for inflation also raises corporate tax burdens.