Chapter 17. The Conduct of Monetary Policy: Strategy and Tactics (Lecture 2)

Transcription

1 Chapter 17 The Conduct of Monetary Policy: Strategy and Tactics (Lecture 2)

2 Lessons for Monetary Policy from the Financial Crisis 1. Developments in the financial sector have a far greater impact on economic activity than was earlier realized Importance of financial markets 2. The zero-lower-bound on interest rates can be a serious problem Nonconventional tools to stimulate economy are less predictable 3. The cost of cleaning up after a financial crisis is very high Economic growth is expected to be low for a decade after the crisis 4. Price and output stability do not ensure financial stability Recent policy by the CBT

3 How should Central banks respond to asset price bubbles? Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst. Alan Greeenspan (former chairman of the Fed): Central Banks should not prick bubbles because: Bubbles are very difficult to identify. If CB knows, why wouldn t market participants know that prices are increasing beyond fundamentals Raising interest rates may or may not be effective in stopping such type of buying behavior Monetary policy affects all markets broadly, not a specific market where there is a bubble MP is a very powerful tool with strong consequences (unemployment, decline in overall price level) that it may do more damage to the economy while trying to prick the bubble It makes more sense to address the problem after the bubble bursts

4 Types of asset-price bubbles Credit-driven bubbles Most dangerous one for the economy Easy creditrise in asset valuesappreciation of collateralmore lending for those assets more demand for the assetsprices go up even more.. Subprime financial crisis Bubbles driven solely by irrational exuberance Driven by expectations (e.g. Tech. Bubble of late 1990s

5 Leaning against the bubble vs. cleaning the bubble afterwards: Recent crisis suggests that CBs should lean against creditdriven bubbles rather than cleaning up afterwards Macropudential policy: regulatory policy to affect what is happening in credit markets in the aggregate. The idea is to curb excessive risk taking Financial regulation and supervision to prevent excessive risk taking Monetary policy: Central banks and other regulators should not have a laissez-faire attitude and let creditdriven bubbles proceed without any reaction.

6 Tools Tactics: Choosing the Policy Instrument Open market operation Reserve requirements Discount rate Policy instrument (operating instrument) Reserve aggregates Interest rates May be linked to an intermediate target An intermediate target is a bridge between the policy instrument and the ultimate goals of monetary policy An intermediate target is easier to measure relative to final goals

7 How does the CB achieve its goals given its tools? 16-7

8 FIGURE 3 Result of Targeting on Nonborrowed Reserves

9 FIGURE 4 Result of Targeting on the Federal Funds Rate

10 By using intermediate and operating targets, CB can more quickly judge whether its policies are on the right track Ex: Suppose the CB thinks 5% is the GDP growth rate at full-emp. (GOAL) To achieve 5% GDP growth, long-term interest rates should be 7%, short-term interest rates should be 4% (INTERMEDIATE TARGET) These interest rate targets are achievable with FFRT=3.5% (OPERATING TARGET) OMO will be conducted to achieve the target (TOOL) 16-10

11 OMOFederal funds rate target (3.5%) Short-term interest rate (4%) Long term interest rate (7%) Investment (10%) Output (5%) 16-11

12 Periodically, CB will check the growth rates/levels of its intermediate targets and readjust its operating target to achieve the desirable level in its intermediate target Difficulty: In real life, it is hard to measure the exact impact of your operating target on your intermediate target or the precise link between the intermediate target and the policy goals

13 Criteria for Choosing the Policy Instrument Observability and Measurability The policy instrument must be easily measured to be informative about where MP stands Nominal interest rates are measured faster than monetary aggregates, however, real interest rates are more difficult to measure It is hard to choose between interest rates vs. monetary aggregates based on this criteria 16-13

14 Controllability The CB should have effective control over the instrument. CB has direct control on overnight nominal interest rates and imperfect control over money (which is determined by public behavior) CB s control over longer term interest rates is harder due to inflation expectations It is hard to choose between interest rates vs. monetary aggregates based on this criteria 16-14

15 Predictable effect on Goals The control over intermediate target should imply indirect control over policy goals. Question: The Fed has switched from a monetary aggregates targeting to interest rate targeting. Why? Answer: The link between monetary aggregates and macroeconomic variables (output growth) weakened (Chapter 19) 16-15

16 End of chapter questions All but 8, 12, 16, 22, 23,