Transcript EPS Session4 2013 (1)

Stabilising the economy: Central
Banks and Monetary Policy
MSc EPS Session 4
Hilary term 2013
Professor Dermot McAleese
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Aim of economic policy is to reduce
volatility of market economy
GDP without
counter-cyclical policy
GDP
GDP with counter-cyclical policy
Potential GDP
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time
OUTLINE
 Price stability defined
 Why is price stability important?
 Role of Central Bank – a broader remit than price
stability?
 Monetary policy – objectives and instruments
 Effectiveness of monetary policy
 New thinking on banking and central banks
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Latin American Inflation, average annual rates
1980-85
1986-90
19912000
2001-04
Chile
21.3
19.3
8.5
3.1
Bolivia
611.0
46.5
12.7
2.1
Mexico
60.8
69.6
15.2
4.7
Argentina
322.5
584.0
9.0
15.0
Brazil
149.0
657.5
434.2
8.7
Peak rate
since
1970
505
(1974)
11705
(1985)
132
(1987)
4924
(1989)
2407
(1994)
Source: IMF, World Economic Outlook, successive issues; Bank of International
Settlements, 64th Annual Report, Basle 2000.
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Price Stability
 a rise in the general level of prices below, but
close to, 2% over the medium term
(ECB May 2003)
 Consumer Price Index (CPI)
 Why not CPI target of 0%?
 Composition bias
 Quality bias
Substitution bias
 Importance of “medium term” – Bank must
not overreact to short term upsurge
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WHAT CAUSES INFLATION?
Inflation is always and everywhere a monetary
phenomenon (Friedman)
Demand shocks (property price boom)
 Supply shocks (food, energy price
increase)
 Budget deficit
 Money supply, increase in loans
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ECONOMIC COSTS OF INFLATION
pp 284-286
 Inefficiency effects
 Redistributive wealth effects
 Adverse dynamics –
inflationary spiral
 Costly to restore price stability
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QUESTION FOR CLASS DISCUSSION
Deflation also a problem
Can be even more damaging
than inflation
Can you explain why?
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TASKS OF CENTRAL BANK
 Monetary policy
 Official foreign reserves
 Exchange rate defence
 Lender of last resort
 Government banker
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THE CENTRAL BANK
Price stability – ultimate objective
Intermediate variables to monitor:
Money supply
Growth of credit
Capacity utilisation
Commodity prices
Order books
Exchange rate
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Speech given by Mervyn King, Governor Bank of England, Belfast 22 January 2013
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THE CENTRAL BANK (2)
Price stability – ultimate objective
…. and , by adhering to this
objective ,
Central Bank will make maximum
contribution to overall
macroeconomic stability.
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Euro Area’s Money Supply
June 2009 (€bn)
• Currency in circulation
• Overnight deposits
735
3,505
€4,240
Narrow Money (M1)
• Short-term Deposits
(Quasi-Money)
• Money Supply (M3)
Source: ECB Monthly Bulletin
M3 at june 2010 is €9,419 bn
5,190
€9,430bn
Memo: GDP 2008 = €9,200 bn 13
POLICY INSTRUMENTS OF CENTRAL BANK
Open market operations
Interest rate
pp318-333
Minimum reserve ratio
----------------------------------------Intervention in forex markets
Direct controls
-------------------------------------------Unconventional measures
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Central Bank Policy Instruments since 2007
Lending Operations
More
More
counter-
liberal
parties collateral
Outright purchases
Longer
term
Forex
Foreign
Swaps Exchange Equities
Private
Gov't
debt
debt
Bail-outs,
capital
injections
√
Australia
√
√
√
Britain
√
√
√
√
√
√
√
√
possible
possible
√
√
√
possible
possible
√
√
√
√
√
√
√
√
√
√
Canada
√
Euro area
Japan
Sweden
√
√
Switzerland
United States
√
√
√
√
possible
√
√
√
√
China
Source: Economist April 2009; DMcA estimates
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Key Policy interest rate
ECB: main refinancing rate
BoE: official bank rate
Fed: target rate
01/01/2011
01/01/2010
01/01/2009
US
01/01/2008
01/01/2007
BoE
01/01/2006
01/01/2005
01/01/2004
01/01/2003
01/01/2002
01/01/2001
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
01/01/2000
ECB
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INTEREST RATES AND ECONOMIC
ACTIVITY (pp 315-318)
THE MONETARY
TRANSMISSION MECHANISM
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MONETARY POLICY AND REAL GDP
1. Substitution effect
(-) i
 (-) S, (+) C
2. Cash flow (income) effect
(-) i

(+) cash flow of borrowers
(-) i

(-) cash flow of lenders
3. Wealth effect
(-) i
 (+) in value of property and equities
 (+) C
4.

(+) I
Cost of Capital (Investment) effect
(-) i

(+) I
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MONETARY POLICY AND REAL GDP
5. Exchange rate effect
(-) i

depreciation of real exchange rate
6. CB credibility effect
(-) i

(+) domestic confidence
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HOW MONETARY POLICY COMBATS DEFLATION
Fig 13.6 p 321
Relax monetary policy
Higher money base
Lower interest rate
Growth in private sector credit
Asset price
boost?
More spending
More output
in short run
Consumer price increase
Price stability and Economic Recovery
More at work
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HOW MONETARY POLICY COMBATS INFLATION
Fig 13.6 p 321
Tighten monetary policy
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If actual output > potential output,
restrictive monetary policy will reduce
dangers of inflation
Objective is to secure a soft landing ….
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If actual output < potential output,
expansionary monetary policy will reduce
danger of deflation
Objective is to secure price stability…
Need for reflation, or “mild” inflation to
solve private debt trap?
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Limitations of monetary policy in
dealing with Deflation
• Nominal interest rate cannot go below zero (ZIRP)
• When prices are falling, real interest rate can stay
high even as nominal rate falls
• Hence monetary policy may not have sufficient
stimulative impact to combat recession
• FUNDAMENTAL LIMITATION: expansionary monetary
policy encourages spending --- but it cannot force
people to borrow and spend
(Also potential danger of overstimulus causing
inflation)
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Reform of the Financial Sector also needed
1. “Too big to fail” banks must be taxed to compensate
taxpayer for implicit government guarantee:
“specific capital surcharges for systemically important
financial institutions can be a useful
tool and should be accompanied by resolution plans
vetted by regulators” (OECD).
2. Structural separation between retail and investment
banking also needed
3. Reduce incentive to get too big to fail by taxing the
equivalent of the implicit guarantee.
4. Improve supervision and incentives system
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Quantitative Easing
a) What is it?
b) Can it help to restore credit growth?
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Limitations of monetary policy in
dealing with Inflation
• High nominal interest rate may be needed to curb
over optimism and restore balance
• Danger or over reaction to short term price changes
• Insufficient attention to asset price movements
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Questions for Group work
1. Define price stability. Why is attainment of price stability important?
2. What intermediate targets can a central bank set to ensure that price
stability is maintained?
3. What policy actions can a central bank take to preserve price stability?
4. Would a cut in interest rates be an effective way of stimulation aggregate
demand in the Euro Area?
5. Does business prefer rising prices (inflation) to falling prices (deflation)?
Or are both equally undesirable? Explain.
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Questions for Group work (2)
Exercise 3 p. 304
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CONCLUSIONS
 Price stability is good for economic growth
 Deflation is just as damaging as inflation
 Aggressive monetary policy necessary to avoid
booms and busts
 But not always sufficient ...
 In times of crisis, fiscal policy also needed
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G20 COMMUNIQUE LONDON APRIL 2009
Monetary Policy in Action
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G20 COMMUNIQUE LONDON APRIL 2009
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