Transcript Contribution of Monetarism in Macroeconomic Policy

Contribution of Monetarism in
Macroeconomic Policy
• Supply of money is the determinant of the national
income
• In the long run, the influence of money is primarily
on the price level and other nominal magnitudes.
Real output and employment are not determined by
monetary factors.
• In the short run the supply of money does affect the
output. Money is the dominant factor in causing
cyclical fluctuations in output and employment in
the short run.
• Private sector is inherently stable and instability is
primarily the result of the government policy.
Macroeconomic Themes:3
1
Policy conclusions
• Stability in the growth rate of money supply is
crucial for a stable economy. Monetarists favour a
constant money growth rate policy rule rather than
discretion.
• Fiscal policy does not have any systematic impact
on real or nominal income.
Macroeconomic Themes:3
2
The basic mechanism of money supply
Households and firms save part of their income. They also borrow
from their banks if their savings are not enough to meet their
expenses.
If deposits are not enough these banks borrow from the central
bank. Central bank lends them by creating reserves at a prespecified interest rate.
By doing so it adds to the monetary base. Given the money
multiplier this translates into the overall supply of money.
This supply along with the given demand for money by the private
sector determines the market interest rate as well as the price level.
Households and firms revise demand for loans based on these new
interest rates and prices.
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3
The basic mechanism of money supply
Government similarly can approach the central bank to finance its deficit.
Central bank creates reserves while lending to the government. This also
raises money supply.
A central bank also buys foreign currency and sells domestic currency.
Money supply expands when economy activities rise and contracts when
they slow down.
Central bank alters the interest rate to increase or reduce the liquidity
required in the economy.
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4
Money Supply
Various types of money: M0, M1, M2, M3, M4 ;
m  1r
Money multiplier:
If we considering a leakage in the currency holding:
m  1r  cc
 M  R C
0
 M4 C  D
(a)
(b)
M D  C 1 c
 then dividing (b) by (a) 4 

.
M C  R cr
0
If people held more currency then multiplier becomes
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smaller.
5
Money Demand
Quantity theory of Money (QTM): MV = PT
Cambridge equation of money demand:
M  kY => M  1   PY
 
P
k 
Keynesian money demand




M   b  b Y  b r
P t 0 1 t 2 t
Friedman type money demand
M  kPY =>




M  k  r e , r b , r D , r  PY
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6
Friedman (1968) on Monetary Policy
Given the natural rates of interest and unemployment,
monetary policy cannot be pegged to lower the interest
rate or the unemployment. Is so it only raises inflationary
expectation and increase in price level. There will be no
impact on real magnitudes.
Monetary authority can control nominal quantities such
as it liabilities, M0, M3 or M4. By controlling them it
can stabilise the price level.
Price mechanism in the market system works better when
prices are stable and relative prices can adjust according
to the dynamics of the economic system.
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7
Natural Rate Hypothesis
 t   e  bu t  u n 
f
LPC
g
d
e
b
c


PC4
PC3
Un
Short run Phillip’s curve
PC
a
PC2
u
un
PC1
Natural rate of unemployment and a
vertical Phillip’s curves
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8
A brief story of monetary policy in the UK
and the EU
Fixed peg system in the Gold Standard and the Bretton Woods.
Exchange rate was the nominal anchor of monetary policy.
Targeting money supply during 1970s. Stop and Go Cycles.
Monetarism in the Thacher and Reagan administrations.
Inflation targeting during 1980s.
Central bank independence during 1990s.
Euro 1999.
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9
retail price index and growth rate of money supply
-5
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10
1998Q4
1997Q2
1995Q4
1994Q2
1992Q4
1991Q2
15
1989Q4
20
1988Q2
1986Q4
1985Q2
1983Q4
1982Q2
1980Q4
1979Q2
1977Q4
1976Q2
1974Q4
1973Q2
1971Q4
1970Q2
Inflation and growth rate of money supply in the UK 1972-2000
30
25
rpi
msgrth
lagp
10
5
0
-2
-4
Macroeconomic Themes:3
-6
growth rate
11
1998Q4
1997Q2
1995Q4
1994Q2
1992Q4
1991Q2
1989Q4
1988Q2
1986Q4
1985Q2
1983Q4
1982Q2
1980Q4
1979Q2
1977Q4
1976Q2
1974Q4
1973Q2
1971Q4
1970Q2
Growth Rate fo real GDP in the UK
12
10
8
6
4
2
0
How does the Bank of England forecast the
inflation?
The economic model of the Bank of England includes
a loss function,
policy reaction function and
intermediate targets.
Core forecasting model that the MPC uses for interest rate
decisions includes 150 variables.
But the model for the pre-MPC briefing is based on charts and
tables of more than 1000 variables. Information for this model is
collected from 12 different branches of the bank around the
country. Inflation target focuses on the domestically generated
inflation (DGI). (John Vickers, Inflation Targeting in the UK,Bank
of England Quarterly Bulletin, 1999 pp. 368-375). The forecasting
model might be summarised in terms of the following diagram
from the MPC.
Macroeconomic Themes:3
12
Transmission Mechanisms of Monetary Policy-Bank of
England’s View
Market
rate
Official
rate
Total demand
Asset
prices
Expectations
and confidence
Domestic
inflationary pressure
Domestic
demand
Inflation
Net external
demand
Import
prices
Exchange
rate
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13
Bank of England’s Fan Chart
Percentage
increase in
prices on a
year earlier
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Source: Inflation Report, Bank of England, November 2000
B&W Figure
9.7
14
Effects of Changes in the Rate of Interest
First round effects
Households: saving, housing, wealth,
foreign asset, portfolio allocations
Firms: cost of capital, debt-equity,
portfolio allocations
Second round effects: consumption
spending, additional demand for goods
Time lags: anticipated and unanticipated
policy changes.
Macroeconomic Themes:3
15
Simple Policy Reaction Function: An
Example of Interest Determination Rule
Impact of interest rate in output


*
*

yt  y  d i  it 
(1)
t

1


where it and it* are actual and natural level of output,
it is the actual rate of interest in period t,
i is the interest target of the monetary authority,
d <0 is a negative parameter.
There is one period lag between the interest rate decision
and the change in the output.
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Simple Policy Reaction Function: An
Example of Interest Determination Rule
The inflation rate responds to the aggregate supply


*
*

 t   t  c y  y 
(2)
t 1
 t 1
where  t and  t* are actual and target inflation rates
Therefore the interest rate determination rule in simple
terms can be written as




*
*
*



it  it  a yt  yt   b t  t 
(3)




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Output
Does Policy Work? Lags and demand
management policy
B
amplified cycle
Business
cycle
A
smoother cycle
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Time
18
Monetarist’s View on Impact of Monetary and
Fiscal Policies
Monetarists view of Monetary policy (IS-LM)
Monetarist view on Fiscal policy (IS-LM)
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19
Monetary Policy Instruments
Money supply targeting
Interest rate targeting
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20
Interest Rate Determination Model: Actual and
Predicted Series
18
PTBIL
TBILLS
16
14
12
10
8
6
4
2
0
0
20
40
60
TIME
80
Macroeconomic Themes:3
100
120
21
Prediction using a Simple Model
Interest Rate Determination Rule : A Simultaneous Equations Estimation
25
PTBIL
TBILLS
20
15
10
5
0
-5
-10
0
20
15
40
60
TIME
PDRPI
DRPI
80
100
120
8
10
PDY
DY
6
4
5
2
0
0
-2
-5
-4
-10
0
20
40
60
TIME
80
100
120
-6
0 Themes:3
20
Macroeconomic
40
60
TIME
80
100
120
22
References
1.
2.
3.
4.
5.
6.
Ball Laurence and Romer David (1990) Real Rigidities and the Non-Neutrality of Money, Review of
Economic Studies, 1990 57 183-203.
Bank of England (www.bankofengland.co.uk) The Transmission Mechanism of Monetary Policy.
Barro and Gordon (1983) A Positive Theory of Monetary Policy in a Natural Rate Model, Journal of
Political Economy, 91:4: 589-610.
Goodhart C.E.A. (1994) What should central banks do? What should be their macroeconomic
objective and operations?, Economic Journal, 104, November, 1424-1436.
Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII
March.
Kydland F.E and E.C. Prescott (1977) Rules rather than discrection: the Inconsistency of Optimal
Plans, Journal of Political Economy, 85:3: 473-491.
Macroeconomic Themes:3
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