Transcript 2 - IES

JEM027
Monetary Economics
Monetary policy implementation
and money supply in normal times
Tomáš Holub
[email protected]
October 12, 2015
Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague
Basic questions
▪ Does the central bank control money supply?
▪ Does the choice of MP regime matter for this?
▪ How is MP implemented in normal times?
▪ How should central banks set the interest rates?
▪ Simple vs. complex interest rate rules – what is
better?
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Introductory quiz (1/2)
A
Money supply is controlled by the central bank
B
Money supply (endogenously) reflects the
economic developments
C
Don’t know
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Introductory quiz (2/2)
A
ST interest rate is controlled by the central
bank
B
ST interest rate (endogenously) reflects
economic developments
C
Don’t know
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Textbook (monetarist) approach with exogenous
money
i
MS
OMO
Monetary base
Money supply
(target)
MD
M/P
▪
CB controls monetary
base (OMO)
▪
Stable or predictable
money multiplier
▪
Key assumption:
stable or predictable
free reserves
Inflation (+output?)
(goal)
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Post-Keynesian approach
▪ CB supplies liquidity at the given
i
interest rate
▪ Weintraub: political motive (when
wages and prices start growing, CB
does not want to create recession,
and thus prefers to increase M)
MS
▪ Kaldor: CB acts as the lender of the
last resort, supplying liquidity
elastically at a given interest rate
▪ Endogenous velocity (effective
MD
money supply is M*V; financial
innovations move V)
M/P
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A debate of the past?!
▪ Exogeneity or endogeneity is not a physical
characteristic of money
▪ It may depend on the length of the period
(short-term vs. medium-term)
▪ It crucially depends on CB‘s monetary policy
and operational regime
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Example: fixed ER regime
▪ With fixed exchange rate,
i
money supply clearly
becomes endogenous
▪ When international
i*
MD
M/P
mobility of capital is
perfect, liquidity is
supplied with infinite
elasticity at the world
interest rate
▪ Mundell-Fleming model
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Problems with monetary base operational
procedure
i
▪
In the short-run, demand for
liquidity may be volatile and rather
inelastic
▪
Fixing the monetary base leads to
large IR volatility
▪
Costly in terms of stability of real
economy, financial stability and IR
predictability
▪
Paul Volcker‘s period in the USA
(1979-82; “non-borrowed reserves
operating procedure”)
▪
“Borrowed-reserves operating
procedure” since then
MS
MD
M/P
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Recall W. Poole (1970)
… IS
… LM
… better to fix IR (implies lower yt
variability); if h is small, the
inequality is more likely to hold
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Modern operational regime
▪ IR as the operational tool
▪ Volume of the OMOs (or other
i
liquidity-providing or sterilizing
operations) is set based on the
estimate of demand
Lending facility
▪ Deposit and lending facility define
Main refinancing rate
Deposit facility
a corridor for acceptable short-term
IR fluctuations
▪ No motivation for banks to keep
much free reserves
▪ Liquidity is endogenous, at least in
MD
M/P
the short-run
▪ In a longer-run: it depends on CB
reactions (i.e. its policy regime)
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Czech interest rates
▪ Usually negligible deviations of short-term PRIBOR rates from 2W repo rate
▪ Currency crisis in 1997 was an intentional exception
▪ Normally a corridor of ±1 p.p. (discount and Lombard rate), in line with ECB‘s
regime (until the global crisis period)
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But: money could still be exogenous-like
▪ CB may react with IRs to
i
target the money supply
▪ Money may thus behave
i’
in an exogenous manner
in the medium run
i
MD‘
MD
M/P
▪ However, most CBs do
not target money supply
(see the demand-formoney lecture), but
something else – e.g.
inflation targeting
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Differences in detail
The details of MP implementation differ among CBs
▪ E.g. Fed funds target rate vs. ECB‘ refinancing rate
▪ Liquidity-providing operations (ECB traditionally) vs. liquidity-withdrawing
operations (CNB)
▪ Full-allotment fixed-rate tenders (Canada, Hungary, ECB now) vs.
variable-rate tender (CNB, ECB normally)
▪ Different maturity of operations (ON, 2W, 3M, …)
▪ Different definitions of eligible counterparties and collateral
▪ Different width of the corridor around the main rate, etc.
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Keynesian economics without LM curve (Romer)
r
▪ Offers a simple
presentational tool ala
IS-LM, AD-AS
MP(π)
▪ More realistic monetary
policy description
▪ CB sets real interest rate
(it sets nominal IR, which
determines real IR given
the inflation persistence)
IS
Y*
Y
Source: Romer D. (2000): “Keynesian Macroeconomics Without the LM Curve”, WP No 7461, NBER
(http://papers.nber.org/papers/w7461)
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Price level indeterminacy (1/2)
▪ Sargent – Wallace (1975): IR-rules lead to price level
indeterminacy in models with rational expectations
▪ For a given i, equations (1)-(3) determine y, r, π
▪ Equation (4) determines m-p only; money supply may
endogenously adjust to any level of prices
(1)
… PC
(2)
… IS
(3)
(4)
… LM
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Price level indeterminacy (2/2)
▪ An equilibrium for the interest
i
M1
M2
rate set by central bank and
with the same real GDP and
inflation is achieved both for
(P1;M1), and for (P2;M2) – or
in principle for an infinite
number of combinations of P
and M
iCB
▪ Thus the price level is
indeterminate
MD(Y,P2)
MD(Y,P1)
M
▪ But: McCallum (1981): this is
true only for “pure interest
rate pegs” (IR path
exogenous, not responding to
endogenous variables)
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Taylor rule (1993)
Federal funds rate and example policy rule
▪
“Discretion vs. policy rules in
practice”
▪
Describes systematic
component of policy
▪
But room is left for judgment
(discretion)
▪
Shown to fit the US Fed funds
rate quite well
▪
Specification in line with
the Fed‘s dual mandate
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Taylor principle (i)
r
▪ If c=0, b must be higher than 1
M1
▪ Intuition: if b<1 , a shock which
r* (π*)
raises inflation lowers the real
interest rate, this increases
output, which further raises
inflation, lowers the real IR…
▪ Therefore, real interest rates
IS‘
▪ Note: too strong reactions may
IS
Y*
must increase with higher
inflation
Y
be a problem, too
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Taylor principle (ii)
r
▪ If b>1, real interest rate is
M1
r* (π‘)
increased after an inflationary
shocks
▪ This pushed the output down (in
r* (π*)
this case closer to equilibrium)
▪ Once the output gap is closed, it
IS‘
causes no further upward
pressure on inflation
IS
Y*
Y
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Alternative rules
MP rules
Optimal
Simple
Backward-looking
Optimized
coefficients
Forward-looking
Estimated
coefficients
Calibrated
coefficients
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Optimal MP rules
var(inflation)
▪ Interest rate reacts to all pieces
of information (all state variables)
▪ Coefficients found to minimize the
expected value of the loss function
▪ Problems: very complex, individual
var(output)
coefficients sometimes counterintuitive, difficult to explain, may not
be robust
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Optimal rules – example (1/2)
Reaction function coefficients
Source: Svensson, L. E. O. (1998): “Open-Economy Inflation Targeting.” London, CEPR Discussion
Paper No. 1989 (October).
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Optimal rules – example (2/2)
Model solution with the wage contracting equation based on CPI
Source: Hlédik, T. (2003): “Modelling the Second-Round Effects of Supply-Side Shocks on Inflation.” WP
CNB 12/2003. (http://www.cnb.cz/www.cnb.cz/en/research/cnb_wp/download/wp12-2003.pdf)
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Forward-looking Taylor rule
▪ Used in many models (including models of CBs)
▪ Inflation forecast reflects all available information
▪ But the rule is much simpler, easy to communicate
▪ With optimized weights, it may get reasonably close to the optimal rule,
and at the same time be more robust
▪ Optimal policy horizon: see Batini – Haldane (1999)
▪ Policy inertia: may reflect policy preferences, uncertainty, etc.
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Fed‘s reaction function
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Some suggestions to extend the Taylor rule
▪ Add the exchange rate for small open economies?
(e.g. L. Ball, 1998, http://www.rba.gov.au/rdp/RDP9806.pdf)
▪ Add the credit growth or some other financial variable?
(e.g. IMF, WEO, October 2009, chapter 3;
http://www.imf.org/external/pubs/ft/weo/2009/02/pdf/c3.pdf)
▪ Include asset prices (e.g. housing prices) in the targeted price
index or separately?
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Conclusions
1
One cannot a priori say, if money supply is controlled by the
central bank, it critically depends on the MP regime
2
Modern MP regimes lead to endogeneity of money (but this
does not mean that the post-Keynesian view was correct,
especially as regards ineffectiveness of MP)
3
In normal times, most CBs with autonomous MP control
the short-term interest rates
4
MP must react sufficiently to stabilize the economy and inflation
expectations (the Taylor principle)
5
Optimal rules may be difficult to interpret and communicate,
and not sufficiently robust
6
Forward-looking Taylor rule often used in practice (with some
controversial suggestions to add further variables)
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