Optimizing Central Bank Operating - Assignment Example

Download file to see previous pages Any central bank which achieves its inflation objective but damages output in a way unacceptable to the community will not keep its mandate for long. It is the recognition of this point which has produced a voluminous discussion and academic literature, which basically asks the question -
central and basic prices (principally wages) will rise faster than this. There is, of course, also the very substantial danger that a rise in non-tradeable prices faster than the target inflation rate will trigger an asset boom, particularly in the classic non-traded asset of real estate property. There is also the issue that, compared with the situation before the capital inflow and appreciation of the exchange rate, interest rates will have to fall: we know that the extra capital inflows are putting
on the exchange rate. Following the reasoning I have outlined so far, the proper response to this is to allow the exchange rate to appreciate. To the extent that this is a long-term or structural change, the inflation-targeting framework would allow the appreciation to be reflected in inflation, to the extent that it meant that non-traded (domestic) prices would rise faster than the target.
On most counts, this is o.k. - it is proper that the relative price between tradeable and non-tradeable changes (in order to encourage the current account deficit that is the counterpart of the financial capital inflows).
a) i ) The introduction of a lagged output gap in this equation is important for comparing inflation and price-level targeting. Conceptually, the lag will be introduced any time friction prevents instantaneous and complete adjustment of output to unexpected changes in the price level. The second equation explains monetary growth. In other words, what the central bank does. Here, they react to offset the output gap (but with a lag), but they do so imperfectly hence the presence of the shock. The last equation simply says that inflation is driven by monetary growth. ...Download file to see next pagesRead More