How does the textbook writer answer the highlighted question on pg.371 and explain the reasons behind the answer.

13.7 Modern Monetary Policy 371 372 Chapter 13 Stabilization Policy and the AS/AD Framework More Sophisticated Monetary Policy Rules music. This commitment to a policy prevents the crew from steering the ship to No central bank in the world mechanically follows a simple monetary policy rule its destruction on the island's rocky coast. like the one considered in this chapter. Nevertheless, these rules are extremely Kydland and Prescott suggest that a similar dilemma, known as a time consis- useful. For one thing, policy rules, as we saw in the previous section, do provide tency problem, is faced by central banks. After firms and workers have formed their a surprisingly accurate characterization of monetary policy in the United States; expectations about inflation and built these expectations into their contracts and the same is true in other countries as well. And the rules may prove useful as pricing strategies, central bankers have an incentive to pursue an expansionary mon- guidelines, even if they're not followed mechanically, both to financial markets and etary policy so that the economy will boom. Firms and workers, however, will antici- to central bankers themselves. Central banks can depart from the guidelines when pate the expansionary monetary policy and build that into their prices. The result their superior information about the state of the economy renders such departures will be a high rate of inflation with no benefit on the output side. If policymakers prudent. As we will see shortly, these rules-as-guidelines may play an important can commit to not exploiting the inflation expectations of firms and workers, the role in helping the central bank stabilize the economy and maintain low inflation. economy can benefit from a lower average level of inflation. This result is exactly The monetary policy rule we've been considering depends only on inflation what an explicit and credible monetary policy rule can accomplish. and not at all on short-run output. At first glance, this may seem odd: Shouldn't Another example of the time consistency problem concerns investments. After the central bank's focus be on stabilizing output when the economy goes into a firms undertake large investments, policymakers may be tempted to tax these recession? Does the sole focus on inflation mean that the central bank doesn't care investments. However, if they know that policymakers will respond in this fashion, about short-run output in some sense? firms will logically be reluctant to invest in the first place. Even if policymakers We could consider richer monetary policy rules in the short-run model, but the say they won't tax the investment tomorrow, once tomorrow comes, they have an fact is that the result typically resembles our AS/AD framework. (You'll see this incentive to renege on their promise. That is, their promise is not "time consistent." in a couple of exercises at the end of the chapter.) The reason for this similarity Policymakers can overcome these time consistency problems by committing is that even our simple rule implicitly puts weight on short-run output. In our themselves to the right policy, as Ulysses did on his ship. In addition to explicit model, changes in short-run output lead to changes in inflation (recall the aggre- policy rules, credibility and a reputation for making the right long-run choices gate demand shock we studied in Section 13.5). Because the policy rule responds can also help policymakers overcome such problems. to changes in inflation, it implicitly responds to the changes in output that cause inflation to change. This is the basic reason why even our simple rule delivers such The Paradox of Policy and Rational Expectations reasonable and realistic results. The ultimate goal that we'd like macroeconomic policy to attain is relatively straightforward: full employment, output at potential, and low, stable inflation. The Rules versus Discretion great paradox of monetary policy is that the best way a central bank can achieve this goal may be to focus on maintaining low inflation and to show a willingness Would we ever want to program our monetary policy rule into a computer and to engineer large recessions in order to achieve that end. The mere presence of a then step back and let the computer be in charge of monetary policy? Or, to return policymaker who is willing to generate recessions to fight inflation may make the to the question posed at the beginning of the chapter, could we replace the chair need to use that policy less likely, thereby leading to the joint goals of economic of the Federal Reserve Board of Governors with a robot? The obvious answer is stability and low inflation. no. It's impossible to allow for every shock and combination of shocks that may How might such a policy show up in our short-run model? A tough stance on hit the economy. Events in the real world are much more complicated than the inflation shows up in the monetary policy rule as a high value of m: the policy- simple shocks in our model, and some discretion by policymakers will always be maker raises interest rates sharply in response to a modest increase in inflation, valuable in these situations. The recent financial crisis provides a perfect example of producing a large recession. To see how such a policy keeps inflation low, we need this point. But a less stringent version of the question is worthy of consideration: to reconsider how workers and firms form their expectations about inflation. Is there any benefit to committing to a systematic policy? Up until now, we've been working with adaptive expectations: we've assumed Finn Kydland and Edward Prescott won their Nobel Prize in 2004 partly for that expected inflation between period / and period / + 1 is simply given by last answering this question. Their answer is summarized nicely in an analogy to period's inflation: Homer's epic poem The Odyssey. In the poem, Ulysses has his sailors bind him to the mast of his ship and fill their own ears with wax before sailing past the island of the Sirens, so that the crew won't be tempted by the Sirens' enchanting In some ways, this is a strange assumption to make. For example, the central bank's target rate of inflation # makes no appearance in this equation. We might Finn E. Kydland and Edward C. Prescott, "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," 'Ben Bernanke gave this analogy in a speech in 2003 when he was a governor of the Federal Reserve but not the Journal of Political Economy, vol. 85 (June 1977), pp. 473-91. chair; see footnote $ for the reference