Answer to Question #289561 in Macroeconomics for REE

Question

(a) Write out the equation that represents the Taylor rule. Then, discuss how the Taylor rule is used to explain the implementation of monetary policy.

(b) Central bank is very importance to determine the economic performance of the country.

(1) What can be done to increase central bank credibility?

(2) Why is central bank credibility important?

(c) Discuss the time inconsistency problem and explain how it relates to monetary policy.

Answer 1

a). r = p + 0.5y + 0.5(p - 2) + 2

in which:

r = represent nominal fed funds rate

p = represent the rate of inflation

y = the % deviation between current actual GDP and the long-term linear trend in GDP

The Taylor rule is a method that can be utilized to anticipate or direct central banks' interest rate changes in response to economic events. When inflation or GDP growth rates are higher than intended, Taylor's rule suggests that the Federal Reserve (FR) should increase the interest rate.

In other words, the Fed will modify its fed funds rate objective by an equally balanced mean of the gap between real inflation and the Fed's preferred inflation rate (presumed to be 2%) and the difference between reported real GDP and a hypothetical intended GDP at a steady-state growth rate (Hayes, 2021). Generally, this means that if inflation or real GDP growth increases above 2%, the Fed will raise its target fed funds rate, and if any of these rises below their respective benchmarks, the Fed will decrease the target rate (Hayes, 2021).

b). Central banks are in charge of a country's monetary policy and supply of money and are frequently tasked with keeping low inflation and steady GDP development. On a macro level, central banks manage lending and borrowing costs by influencing interest rates and participating in financial markets.

b1). Improving independence, openness, accountability, and the monetary policy plan can all impact the central bank's credibility and reputation. Autonomy means ensuring it is not influenced by other parties like politicians and is activities are in the public domain. Transparency involves being accountable for all transactions involving public or private institutions. Finally, although there is broad agreement that CK autonomy and openness are crucial to maintaining credibility, it is also evident that they must successfully control inflation performance or the success of a particular monetary policy regime.

b2). Credibility ensures that the CB deliver their role without justly and impartiality without any discrimination or corruption. When investors believe in a central bank's ability to maintain price stability, the central bank has to do less to maintain it. In the absence of credibility, more forceful action is required to attain the same goal. Generally, when there is a lot of ambiguity, credibility becomes even more vital.

c). time inconsistency problem and monetary policy.

Time-inconsistency refers to circumstances in which policies that were assessed to be optimal previously are no longer considered to be ideal today and are thus not enforced. The lack of implementation of these policies could lead to implementation of inflationary measures in their place. In essence, time inconsistency may lead to increased inflation.

Reference

Hayes, A. (2021, February 26). Taylor rule. Investopedia. https://www.investopedia.com/terms/t/taylorsrule.asp