We have made monetary policy look easy. The effects of the actions of the monetary authority are summarized by Figure 10.2 “The Monetary Transmission Mechanism”. Given a choice of a target inflation rate and a target level of economic activity, the Fed (and other central banks) ought to know exactly what to do to reach these goals. So why are central bankers so vital to the functioning of the macroeconomy? What Is the State of the Economy? In Section 10.3.3 “Closing the Circle: From Inflation to Interest Rates”, we described the Taylor rule as relating the target federal funds rate to the state of the economy, specifically the inflation rate and the output gap. As a matter of theory, this is straightforward to describe. The practice is rather harder. First, it is a significant challenge simply to know the current state of the economy. In the United States, part of the preparation for FOMC meetings is an attempt to figure out the current output gap and other variables. The Board of Governors of the Federal Reserve has a large staff of professional economists, as do the various regional Federal Reserve banks. These economists spend much of their time helping the members of the FOMC understand the current state of the economy. One particular problem is that the level of real GDP itself is calculated only on a quarterly basis. Potential GDP, meanwhile, is a theoretical construct that requires some guesses about “full employment.” It is not directly measured. So if the Fed learns that real GDP is growing rapidly, it has to judge whether this is because potential GDP is growing rapidly or because actual GDP is above potential. Since the Fed does not meet to determine policy each day and the Fed’s policies themselves take time to work through the economy, it is not even enough to know the current state of the economy. The FOMC must also forecast the state of the economy for the near future. One talent of the previous Fed chairman, Alan Greenspan, was apparently his use of relatively unorthodox sources to get a sense of the state of the economy. What Are the Effects of Monetary Policy? Even if there were no uncertainty about the current state of the economy—that is, the inflation rate and the output gap—monetary policy is still difficult for other reasons. First, as we emphasized earlier, the Fed does not have direct control over the long-term real interest rates that matter for durable goods spending. The Fed can influence a short-term nominal rate, which in turn influences the long-term real rates. But the exact link from one interest rate to the other is not known by the Fed and may change over time. The Fed may fail to achieve the long-term rate that it is aiming for.
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