Transcript The Political Economy of Exchange Rate Policy

Political
Economy
of
Monetary Policy
November 2003
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Presentation Index
> Introduction.
> Areas of Interest.
– Endogenous Monetary Policy Formulation
– Fiscal and Monetary Policy
– Foreign Exchange Arrangement and Monetary Policy
– Unemployment, Inflation and Monetary Policy.
> Q&A
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Introduction
•The objective of monetary policy is to influence the performance of the economy as
reflected in such factors as inflation, economic output and employment. It works by
affecting aggregate demand across the economy, specifically peoples’ and firms’
willingness to spend money on goods and services.
•Monetary policy is conducted by a nation’s central bank and influences demand by
targeting (raising or lowering) short term interest rates or controlling the money
supply.
•Monetary policy has two basic goals: to promote “maximum” output and
employment, and to promote “stable” prices.
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The presentation will be based on certain aspect of political
Economy and monetary policy
• Kliponen
• Parkin
• Edwards
• Frieden
• Leblang
Monetary Policy
• Havrilesky
• Bach
• Kaley et al
• Persson et al
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The Political Economy of Monetary Policy (Havrilesky, 1994)
Objective
> Determine the factors the influence the
endogenous process of monetary policy
formulation.
Public Choice Model
> Two variations: central bank‘s burocreatic self
interest and redistributive considerations.
> Monetary policy therefore responds neither to targets
for output or inflation, but reacts to political
pressures resulting from sectoral dissonances.
Previous Theories
> Keynesians: Central bank is seen as an
independent manipulator of int, exchange,
unemployment and growth rates.
> An apolitical institution in charge of choosing the
optmital instruments and target variables.
> Game Theory: Central Banks play indefinite lossminimizing games with atomistic market
participants whose voting power generates the
only incentives
> Models do not deal with the reciprocity between
interests groups, politicians and central bankers
> Partisan Theory: MP is somehow driven by
economic preferences of voters, since they know
politicians preferences, but still face electioral
uncertainties.
> Rent seeking by interests groups places strong
pressures on monetary policy making (directly or
indirectly), so that income is redistributed through
inflation or interesta rates.
> For eg, MP will respond to contain inflation only when
the “cost“ of it (in terms of aggregate wealth) exceeds
the cost of interests groups organizing to lobby for
monetary restrains.
> The government‘s reaction function changes every
time there is a change in the political environment
(incluidng but not limited to elections)
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“Optimal Fiscal and Monetary Policy and Economic Growth”
– Foley et al (Journal of Political Economy)
Government goals:
•
Maximization of utility of per capita consumption (social welfare)
•
Management of aggregate demand to achieve stable consumer price level (maintenance of
price stability)
Government tools:
1. “Its deficit appears as transfer income and influences the demand for consumption goods.”
2. It intervenes at the asset market by open market policy – it affects price of capital and therefore
economy’s growth path.
(Therefore, it manipulates deficit and OMP to induce the private sector to produce investment goods
at the optimal rate at each instant).
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•
•
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Optimal per capita deficit is an increasing function of the capital labor ratio.
Initial debt has no influence on economy’s growth path; Economy’s growth possibilities are only
constrained by its technology and its initial endowments of capital and labor.
The economy seeking the higher long-run per capita consumption (less impatient government)
may follow a fiscal and monetary policy leading to a higher long-run per capita debt.
The higher the community’s propensity to save, the higher is the long run debt (taking the
government's objective function as given).
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“Monetary-Fiscal Policy Reconsidered” - G.I. Bach
(Journal of Political Economy)
• “Instead of guaranteeing full employment without inflation, in a free society monetary-fiscal
policy may well guarantee inflation without full employment because of the upward income
pressures of monopolies and organized political power groups”.
• Government has two goals – price stability and full employment
• Author proposes 6 assumptions for the workable monetary-fiscal policy; One of them is: “For
effective policy monetary-fiscal authority must operate without irresistible pressures from special
interest groups (business, labor and agriculture) seeking to place their welfare above that of the
general public”.
• While interest groups are exerting expansionary pressures on government, Government is
acting as a protector of the income of a particular social group – the unorganized fixed-income
receivers.
• Upward income and price pressure cannot be effectively resisted by a government whose
monetary-fiscal guide is “full employment”.
• Necessary condition for successful monetary-fiscal policy is voluntary consensus among
interest groups (public support).
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“Time Consistency of Fiscal and Monetary Policy “ –
Persson et al (Econometrica)
• The problem of time inconsistency arises from:
1) Incentive for each government to engage in an initial unanticipated inflation
2) Incentive for each government to deviate from the path of taxes announced by the
preceding government
Government under discretion has an incentive to deviate from previously announced policy.
•
Suggestions: 1) Fixed rules – commitment policy
2) Reputation issue (allows discretion policy)
3) Carefully managed structure of debt – each new government had to honor
the previous government debt (allows discretionary policy)
1 - Each government should leave to its successor net nominal claims on the private sector
equal to the money stock
2 - Government has to engage in partial commitment – just to honor previous national debt.
New government inherits the right maturity structure of its nominal and indexed debt, which
enables it to conduct optimal policy without time inconsistency.
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Exchange Rate and the Political Economy of Macroeconomic
Discipline (Edwards, 1996)
Research Objective
> Determine the factors the influence the choice of a
particular exchange rate arrangement.
Results
Sign on
Coefficient
Political Instability
Bilateral exchange-rate changes
Variation of real export
Methodology
> Constructs a data set of 63 countries (developed
and less developed) covering 1980-1992.
> Constructs a theoretical model contrasting the
effects of political instability and the authorities
discount rate in the ex-ante decision of chosing
the exchange rate regime
> Runs a probit regeression, setting the dependant
variable to be the probability of choosing a
pegged regime.
Degree of Openness
Domestic Liquidity’s Growth Rate
Inflation History
International Reserves
Real GDP growth
Per Capita GDP
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The Political Economy of Currency Pegs (Frieden, 2003)
The Political Economy of Exchange Rate Policy (Leblang, 2003)
Research Objective (Frieden)
> The exchange rate policy reflects a government’s tradeoff
between the competitiveness of tradable goods (influenced
by interests groups) and antiinflationary credibility.
Methodology
> Test these arguments with Hazard models to analyze the
duration dependence of Latin American exchange rate
arrangements from 1960-1999
Findings
> An impending election increases the conditional likelihood
of staying on a fix peg system by about 8%
> After the election, the probablility of going off a peg increaes
by 4%
> Controlling for economic factors, 1% point increase in the
size of the manufacturing sector in the country, is
associated with a reduction of six months in the longevity of
the country‘s peg.
Research Objective (Leblang)
> Government’s decision to defend the peg reflects
institutional, electoral and partisan incentives.
Methodology
Test the hypotheses from this model on a sample of 90
developing countries between 1985 and 1998 using a
probit model
Findings
> All other things being equal, the empirical evidence
indicates that speculative attacks are more likely:
> (i) under left rather than under right governments
> (ii) after electionsrather than before them. (due to short
term governmetn spending)
> Aside from economic fundamentals, markets take into
account the timing of elections and the partisanship
orientation of the government
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The Political Economy of Monetary Policy and Wage
Bargaining (Kilponen, 2000)
When wage setters commit to an inflation targeting régime, inflation can reach the target level,
but there may be a substantial loss in output. The loss in output is related by the desire of the
central bank to accommodate related labor market distortions.
When labor markets are sufficiently decentralized, regardless of the weight the government
attaches to output stabilization, the government would prefer explicit inflation targeting over
discretion even if the wage setters had a possibility to precommit. Additionally, under
discretion, the whole society would be better off, especially unions.
When the wage setters responded to the policy rule of the government, it was found that the
government’s policy was not time inconsistent in the usual sense of creating inflationary bias,
because the government would find it optimal to reduce inflation.
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Unemployment and Inflation (Parkin, 1998)
Optimally, monetary policy should set a short term interest rate and a contingency rule to
target zero inflation, and to smooth out fluctuations in unemployment.
The general view is that the natural unemployment rate fluctuates and the trade-off between the
change in inflation and unemployment is influenced by many factors: rates of entry and exit
into job market, unemployment compensation arrangements.
The trade off between the change of unemployment and inflation is of limited policy relevance.
Dynamic General Equilibrium (DGE) Model-shows the design and conduct of monetary policy
would make predictions about the influence of monetary actions on unemployment and
inflation.
Combines production technology, job matching technology, shopping-time technology, and
price setting technology into one model.
Shocks to this model would show how other sectors would recover when one sector is
hampered.
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