Transcript Document

MBA34
Monetary policy
Managerial Excellence – 1° Term
Class 19
The firm and its environment - Francesco Giavazzi
Copyright SDA Bocconi 2008
Monetary Policy Lecture 1: theory
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Motivating Questions
• How to predict monetary policy ?
– How low will the Fed push interest rates in 2009 ?
– Will the ECB cut interest rates despite rising inflation?
• What are the effects of monetary policy?
– Will there be a US recession in 2008 ?
– What will happen to the $ or the Pound in 2008 ?
– How long will credit crunch continue ?
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Outline
1. Some terminology
2. The effects of monetary policy
3. The role of monetary policy - Goals and
strategies
4. Monetary policy in practice
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1. Some terminology
Operating
instrument
=
almost always
interest rates
Intermediate
targets
=
money supply, credit,
exchange rate, inflation
forecast
Final
objectives
=
inflation, output
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The Monetary Policy Instrument in
the Euro area
The minimum bid rate for the main refinancing operations is
the key ECB interest rate
Weekly frequency auctions, two-weeks maturity
The amount is assigned at the rate proposed by the bank in
descending order (bids are listed from the highest to the
lowest offered interest rate)
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The monetary policy instrument
in the US
• Fed funds rate (overnight interbank rate)
• The Fed chooses a target rate (Fed funds
target)
• Trading desk of NY Fed intervenes in the Fed
funds market to keep mkt rate as close as
possible to target
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Market
Rates
Asset
Prices
How CB decisions affect
the economy - The
“monetary transmission
mechanism”
Demand
Official
Rate
Output &
Inflation
Expectations
/Confidence
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Supply
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2. The effects of monetary policy
Tighter monetary policy (MP)
 temporary and delayed fall in Y
 permanent and delayed fall in P
i.e. MP is non-neutral in the short run
- “Neutrality” of MP? As money supply changes, real
GDP and other “real” variables stay unchanged
- Source of non-neutrality? “Nominal rigidity”,
namely: prices, or wages, or debt contracts, set in
advance, hence fixed in nominal terms
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Key points to remember
• Expected MP is “neutral”
• Unexpected MP is “non-neutral”
• Why? “Expected” MP is embodied in contracts,
“unexpected” is not
• Nominal rigidities create a role for unexpected MP
Underlying idea: Central Bank can act first, reacting to shocks,
for it has “information advantage”. Workers and firms cannot
or can do it more slowly
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P
The effects of EXPECTED expansionary monetary
policies -- no GDP gains, only inflation
E’
E
AD’
AD
GDP
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Permanent GDP
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P
The effects of UNEXPECTED expansionary
monetary policiesSRAS’
E’’
SRAS
E’
E
AD’
AD
Permanent GDP
GDP
Temporary GDP gains, no long-run gains
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Why GDP gains are only there in the short run
Monetary expansion (unexpected cut in policy rate) shifts AD to
the right
In the short run, GDP gains. Yet such gains don’t last forever.
Let’s see why
 AD increase also makes P go up
 Over time P feeds into higher nominal wages
 Why do wages go up? At next wage bargaining: wage
claims due to today’s P. AS shifts to the left
 As nominal wages change, short-run AS (entire curve) shifts
to the left. It’s a cost of production increase
 Short-run AS keeps shifting leftwards until GDP above its
long-run average
 Adjustment stops when GDP back to its long-run average
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3. The role of monetary policy
MP supposed to stabilize GDP, P shocks
keep GDP= GDP*, π = π* (inflation close to target,
may be 2%)
• Two kinds of shocks
– Aggregate demand (eg. House prices fall)
– Short run aggregate supply (eg. oil or commodity
prices)
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Aggregate demand shocks
– housing prices fall, AD shifts to the left
Inflation
Y=Y*
Aggregate demand
Try to stabilize demand shocks –
Y
no trade off between Y and P
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Aggregate supply shocks
– oil price rises, short-run aggregate supply to the left
Inflation
Y=Y*
Aggregate demand
Y
Difficult choice – trade off between Y and P
Optimal policy depends on their relative cost
In practice: let P rise, but avoid “second round effects” (do not
validate expectation that price rise will continue Monetary
in the
future)
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4. Monetary policy in practice
Long-run price stability today recognized as overriding
goal of monetary policy both by governments and
central banks.
Implementation controversies
 Are there other objectives of monetary policy? If yes,
which priorities?
 Are monetary policy goals best achieved if CBs conform
their behavior to a rule? Should this rule be explicit or
implicit?
Two sets of alternatives
 hierarchical/dual mandate
 implicit/explicit inflation objective mandate
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Monetary policy rules around the world
Many countries have adopted ‘inflation-targeting’
regimes, i.e. hierarchical & explicit mandates
US Fed: dual & implicit mandate
 Over time, goals interpreted by Greenspan. “Price
stability means inflation so low and stable that it is
ignored by households and businesses”
 With Bernanke, gradual and hidden evolution
towards inflation targeting. Fed announces inflation
forecasts at 3 years – same as inflation targeting
ECB
 Not an explicit inflation-targeting regime, but price
stability is primary objective (Art.105, Maastricht
Treaty) and Governing Council sets explicit (now 02%) inflation target
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Inflation-targeting regimes
Usually: hierarchical mandate
Price stability = primary objective
 goal: point-wise (often 2% per year) or within a range
(often 1-3%)
Measure of inflation
 comprehensive measures (e.g. CPI) vs. measures of
‘core’ or ‘underlying’ inflation
Flexibility recovered through escape clauses
Beyond explicit targets, program includes period over
which deviations have to be eliminated (18-24 mths)
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The Taylor rule
In practice most central bankers implement inflation
targeting following unofficial rule of thumb in setting R.
This is the Taylor Rule (from John Taylor, Stanford
economist)
Rt = r* + * + c (-*) + d (output gap)
R = target policy rate (e.g. discount rate)
r* = long-run level of target rate in real terms
* = long-term goals for inflation (2%?)
 = actual inflation
c, d = positive constants, measuring CB response to
deviations of inflation and output from their long-run
values (output gap=y-y*)
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Implications from Taylor rule
1.
As =* and y=y*, the nominal discount rate R
should stay constant equal to its long-run level (=
r* + *)
2. As economy overheats (eg positive AD shock), R
should go up for >* and y>y*. The opposite if
economy hit by negative AD shock
3. What should central bankers do with asset (foreign
exchange, stock, bond, housing) markets? If CB
follows Taylor rule, it should do nothing as such
to counteract asset market bubbles or bubble
bursting, UNLESS asset price behavior is threat
to stability in inflation or GDP. In practice, a
straight jacket.
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Implications from Taylor rule
A big problem when the economy is hit by negative
supply shock (oil or commodity prices up or
upward shift of wages)
Rule doesn’t give unambiguous indication about what
to do with R
 >*  R should go up
 y<y*  R should go down
Net effect on R depends on values of c and d
 Need estimate of “c” and “d” in the Taylor rule from
past data on inflation, GDP, discount rates
 Plausible values: c=1.5, d=0.5
 If c<1, Taylor rule would be de-stabilizing. Why?
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Credibility and comunication are key
in inflation targeting programs
Eg. New Zealand
•  > *
• Under inflation targeting, financial markets
expect restrictive MP (and short term interest rate
R to go up)
• exchange rate appreciates
• As exchange rate appreciates exports go down,
imports more competitive. Aggregate demand
down, with no need to raise short term R
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Typical dilemmas in small open economies:
how to react to exchange rate changes
Eg. New Zealand vs Australia
• Asian financial crisis late 1990s
• Exchange rate depreciates =>  rises
• Australia: let  rise without raising R =>
good outcome (Y stable,  fell eventually)
• New Zealand: fear of rise in e => raises R
=> deep recession
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