Transcript EPS Session4 2011

Stabilising the economy: Central
Banks and Monetary Policy
Topic 4
MSc EPs
Hilary term 2011
Professor Dermot McAleese
1
Aim of economic policy is to reduce
volatility of market economy
GDP without
counter-cyclical policy
GDP
GDP with counter-cyclical policy
Potential GDP
2
time
PRICE STABILITY AND THE CENTRAL
BANK
 Price stability defined
 Why is price stability important?
 Role of Central Bank
 Monetary policy – objectives and instruments
 Effectiveness of monetary policy
3
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.
4
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)
 Sources of measurement bias
 Composition bias
 Quality bias
 Substitution bias
Note: Should asset prices be included in CPI?
5
WHAT CAUSES INFLATION?
Inflation is always and everywhere a monetary
phenomenon (Friedman)
Demand shocks (property price boom)
 Supply shocks (oil, energy price
increase)
 Budget deficit
 Money supply
6
WHAT CAUSES DEFLATION?
Demand shocks (property price fall; stock
exchange collapse)
Supply shocks (interest rate increase)
Budget surplus
Money supply – credit reduction
7
ECONOMIC COSTS OF DEFLATION
(DMcA pp 284-286)
 Inefficiency effects
 Redistributive wealth effects
 Adverse dynamics –
deflationary spiral
 Costly to restore price stability
8
Fisher’s Paradox
The more debtors pay, the more they owe.
(the chief secret of most if not all great
depressions)
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JAPAN’S DEFLATION (Box 12.1 pp 290291)
 Land prices and commercial property fall by 50% 19901995. Commercial estate prices fall 87% in real terms
(Koo, 258)*
Nikkei index falls from 38,900 in 1989 to under
10,000 (just over 7.000 in March 2009)
 Consumers prices decline
 “Adverse dynamics” dominant
 Combination of debt and deflation
‘a lethal cocktail’. Balance sheet recession
 ‘Zero interest floor’ problem
* Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 200910
Japan's Deflation 1995-2010
2.0
1.0
0.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
-1.0
-2.0
Source: CPI data, taken from World Bank, OECD
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TASKS OF CENTRAL BANK
 Monetary policy
 Lender of last resort -- preservation
of financial system
----------------------------- Exchange rate defence
 Manage official foreign reserves
 Government banker
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THE CENTRAL BANK
Price stability – ultimate objective
Intermediate targets
 Money supply
 Inflation ‘lead’ indicators
 Exchange rate
Employment, economic growth?
13
Objective European Central Bank (ECB)
Primary objective of the Eurosystem is to
maintain price stability.
14
TASKS of Federal Reserve Bank
Objective is “to attain maximum employment,
stable prices and moderate long term interest
rates”.
15
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 ECB Sep 2010
5,190
€9,430bn
Memo: GDP 2008 = €9,200 bn 16
ACHIEVING PRICE STABILITY
 Political commitment
 Institutional framework
 Independent Central Bank
 Clear policy objective
 Fiscal sustainability
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European Central Bank (ECB)
Neither the ECB, nor a national central
bank, nor any member of their decisionmaking bodies shall seek or take
instructions from Community
institutions or bodies, from any
government of a Member State or from
any other body.
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POLICY INSTRUMENTS OF CENTRAL BANK
Open market operations
Interest rate
DMcA
pp318-333
Minimum reserve ratio
----------------------------------------Intervention in forex markets
Direct controls
-------------------------------------------Unconventional measures
19
Euro banknotes in circulation
December 2007 (€677bn)
Banknotes
€5
€10
€20
€50
€100
€200
€500
No of notes
(m)
1,300
2,000
2,250
4,500
1,200
150
480
Value (€bn)
Source: computed from ECB Annual Report 2007
6
20
45
220
120
30
240
20
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
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
ECB
BoE
ECB: main refinancing rate
BoE: official bank rate
Fed: target rate
01/01/2009
01/01/2008
01/01/2007
01/01/2006
01/01/2005
01/01/2004
01/01/2003
01/01/2002
01/01/2001
01/01/2000
US
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EEAG report feb 2010 (updated)
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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
 (-) Saving, (+) Consumption
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
 (+) Consumption
4.

(+) Investment
Cost of Capital (Investment) effect
(-) i

(+) Investment
25
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
27
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?
29
Limitations of monetary policy
• Nominal interest rate cannot go below
zero (ZIRP)
• When prices are falling, real interest
rate can stay high even as nominal rate
falls
• Monetary policy encourages spending
but cannot make it happen
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Questions for Group work
1. Define price stability. Why is attainment of price stability important?
2. What policy actions can a central bank take to prevent deflation?
3. Can the use of monetary policy on its own cure a recession? What are the
limits to its effectiveness?
4. Q 3 p. 303 --- does business prefer rising prices to falling prices?
5. What actions if any should the ECB take to reduce the Euro area’s high
unemployment rate?
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You can tell whether a man is clever by his
answers.
You can tell whether a man is wise by his
questions.
Naguib Mahfouz
Nobel Prize for Literature 1988
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Exercise 5 p. 332
During 2003-4, as nominal interest rates fell to near zero, there was much
discussion of the need for central banks to have recourse to
‘unconventional measures’ in order to stimulate aggregate demand.
These measures included:
a)
b)
c)
d)
e)
Direct increases of the monetary base
Purchase of corporate debt
Purchase of government bonds to reduce long term interest rates
Buying private securities to boost asset prices
Explicit commitment to higher inflation target of 3 per cent.
Analyse how each of these measures might be expected to impact on
aggregate demand.
CONCLUSIONS
 Price stability is good for economic growth
 Deflation is just as damaging as inflation
 Aggressive monetary policy required to prevent
deflationary adverse dynamics taking hold
 In times of crisis monetary policy not enough on its
own. Expansionary fiscal policy also needed
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G20 COMMUNIQUE LONDON APRIL 2009
Monetary Policy in Action
35
Monetary Policy not enough ….
…….. in current conditions monetary policy
will be insufficient.
This is a Keynesian situation that requires
Keynesian remedies. Budget deficits will end
up at levels previously considered
unimaginable.
Martin Wolf Financial Times Wed 22 Oct 2008
36
OECD Economic Outlook Nov 2009 p. 38
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