ME II, Prof. Dr. T. Wollmershäuser. Chapter 8 Monetary Policy Transmission: IS-MP-PC-Analysis

Transcription

1 ME II, Prof. Dr. T. Wollmershäuser Chapter 8 Monetar Polic Transmission: IS-MP-PC-Analsis Version:

2 Shortcomings of the IS-LM-Analsis Ultimate goal of the ECB: Price stabilit (formulated in terms of an inflation target) no output targeting as in the IS-LM model Instruments of the ECB: Direct control over short-term mone market rates (via open market operations) and indirect control over credit interest rates no direct control over mone as in the IS-LM model new model: IS-MP-PC ME II, Prof. Dr. T. Wollmershäuser, Slide 2

3 Monetar Transmission Process Instruments of the ECB (e.g. main refinancing operations) Mone market rates, refinancing costs of banks Credit interest rates of the private and public sector Aggregate demand (prices and, inflation, real GDP, unemploment rates) Operating targets Intermediate targets Final targets Mone / credit suppl process Chapter 7 Transmission process Chapter 8 ME II, Prof. Dr. T. Wollmershäuser, Slide 3

4 Monetar Transmission Process 2 x 1 3 GDP 4 x 1 3 Inflation (HICP) 5 x 1 3 Inflation (Wages).2 Inflation (Commodities) x x x M-Euribor Credit rates priv. Consumption Investment ME II, Prof. Dr. T. Wollmershäuser, Slide 4

5 Monetar Transmission Process Impulse responses show the reaction of a variable following a monetar shock: prior to the shock all variables were at their equilibrium values (here: normalized to zero) if time goes to infinit all variables will be at their equilibrium values (here: normalized to zero) monetar neutralit The horizontal axis depicts time in quarters Inflation and interest rates are measured in percent =.3 =.3 percentage points = 3 base points (in case of interest rate) deviation from equilibrium GDP and its components are measured in levels (indices) =.2 =.2 percent deviation from equilibrium ME II, Prof. Dr. T. Wollmershäuser, Slide 5

6 Monetar Transmission Process ME II, Prof. Dr. T. Wollmershäuser, Slide 6

7 Monetar Transmission Process Interest rate channel Expectations channel (Exchange rate channel, asset price channel, quantit theor channel,...) ME II, Prof. Dr. T. Wollmershäuser, Slide 7

8 Interest Rate Channel Changes in mone market rates have an impact on the interest rates set b banks on short-term loans and deposits. In addition, expectations of future official interest rate changes affect longer-term interest rates, since these reflect expectations of the future evolution of shortterm interest rates. What are the macroeconomic effects of higher credit / deposit rates? Changes in interest rates affect the saving, spending and investment decisions of households and firms, and hence aggregate demand. ME II, Prof. Dr. T. Wollmershäuser, Slide 8

9 Interest Rate Channel Higher interest rates tend to make it less attractive for households or companies to take out loans in order to finance their consumption or investment. Other channels: Higher interest rates make it more attractive for households to save their current income rather than spend it, since the return on their savings is increased. Changes in official interest rates ma also affect the suppl of credit. For example, following an increase in interest rates, the risk that some borrowers cannot safel pa back their loans ma increase to a level such that banks will not grant a loan to these borrowers. As a consequence, such borrowers, households or firms, would be forced to postpone their consumption or investment plans. ME II, Prof. Dr. T. Wollmershäuser, Slide 9

10 Interest Rate Channel Financial structure of the euro area low debt securities issuance of the private sector low stock market capitalization important role of bank loans Source: ECB (24), The monetar polic of the ECB ME II, Prof. Dr. T. Wollmershäuser, Slide 1

11 Interest Rate Channel The investment function assumes a direct impact of interest rates on investment demand If investment is mainl financed b credit an increase in credit rates reduces the expected return on the investment project investment therefore negativel depends on interest rates ME II, Prof. Dr. T. Wollmershäuser, Slide 11

12 Interest Rate Channel IS-LM model IS/MP/PC model i π =, i = r r π, i r I(i) I(r) I Investment demand depends on the real interest rate (r). I ME II, Prof. Dr. T. Wollmershäuser, Slide 12

13 Nominal versus Real Interest Rates Interest Rates expressed in units of the national currenc are called nominal interest rates (i). Borrowing one euro this ear requires ou to pa 1 + i t euros next ear. Interest rates expressed in terms of a basket of goods are called real interest rates (r). Borrowing the equivalent of one basket of goods this ear requires ou to pa the equivalent of 1 + r t baskets of goods next ear. ME II, Prof. Dr. T. Wollmershäuser, Slide 13

14 Nominal versus Real Interest Rates Definition and Derivation of the Real Interest Rate i t = nominal interest rate for ear t. r t = real interest rate for ear t. (1+ i t ): Lending one dollar this ear ields (1+ i t ) dollars next ear. Alternativel, borrowing one dollar this ear implies paing back (1+ i t ) dollars next ear. P t = price this ear. P e t+1 = expected price next ear. ME II, Prof. Dr. T. Wollmershäuser, Slide 14

15 Nominal versus Real Interest Rates Given: e Pt e P 1 + rt = (1 + it) t+ 1 Pt and e π t P t + 1 Pt Pt 1 Then: = e e P t+ 1 (1 + π t) 1+ it Consequentl: (1 + rt ) = e 1 + π If the nominal interest rate and the expected rate of inflation are not too large, a simpler expression is: e r i π ME II, Prof. Dr. T. Wollmershäuser, Slide 15 t t t The real interest rate is (approximatel) equal to the nominal interest rate minus the expected rate of inflation. t

16 Nominal versus Real Interest Rates Present value of an investment V t P Y V P Y Y V PI I I e e t+ 1 t+ 1 t t+ 1 t+ 1 t+ 1 t = t t = t = t 1+ it Pt ( 1+ it ) Pt 1+ rt The decision to realize an investment depends on its present value. On average it is reasonable to assume for all firms that the price of their goods increases with the overall price level. If the present value of the future return Y t+1 from the investment I t exceeds toda s investment expenditure P t I t the investment is realized. Firms evaluate the real value of their investment toda. ME II, Prof. Dr. T. Wollmershäuser, Slide 16

17 Interest Rate Channel IS curve goods market equilibrium: Y = C( Y T) + I( Y, r) + G = c + c ( Y T) + b + by b r + G c + b b2 G ct 1 Y = r + 1 c b 1 c b 1 c b natural level: Y n c + b b2 Gn ct 1 = rn + 1 c b 1 c b 1 c b n ME II, Prof. Dr. T. Wollmershäuser, Slide 17

18 Interest Rate Channel IS curve expressed as percent deviation from the natural level: Y Yn = = a br + ε1 where ε1 N, σ ε 1 Y G = G and T = T 1 ME II, Prof. Dr. T. Wollmershäuser, Slide 18 n ( ) in the medium run the output gap is closed: n n ε = (thus, changes in government spending and taxes are interpreted as demand shocks) the natural level of the interest rate is given b: = = a br n rn = a b

19 Expectations Channel Through the expectations channels monetar polic can influence price developments b influencing the private sector s longer-term expectations. Central banks have a medium-term inflation objective: If a central bank enjos a high degree of credibilit in pursuing its objective, monetar polic can exert a powerful direct influence on price developments b guiding economic agents expectations of future inflation and thereb influencing their wage and price-setting behavior. The credibilit of a central bank to maintain price stabilit in a lasting manner is crucial in this respect. Onl if economic agents believe in the central bank s abilit and commitment to maintain price stabilit, inflation expectations will remain firml anchored to price stabilit. ME II, Prof. Dr. T. Wollmershäuser, Slide 19

20 Expectations Channel According to the Phillips curve inflation expectations have a direct impact current inflation. wage-price mechanism (AS-AD analsis) If inflation expectations are firml anchored at the level of the inflation target, then the inflation target enters the wage bargaining process. ME II, Prof. Dr. T. Wollmershäuser, Slide 2

21 Expectations Channel most general formulation of the Phillips curve π = π d u ( u ) e t t t n note: now d instead of α introduction of the output gap t inflation expectations are anchored at the level of the central bank s inflation target π new formulation of the Phillips curve π =π +d t ME II, Prof. Dr. T. Wollmershäuser, Slide 21 t ( 1 ) ( 1 ) t n ( 1 u ) L Y Y u L u L u u t n t n = = = u u Y 1 u ( ) t t n n n n π e =π t

22 Expectations Channel Given the inflation expectations anchored at the level of the central bank s inflation target, short run deviations of production from its natural level following a temporar shock lead to changes in the current rate of inflation. Credibilit of the inflation target means, that inflation expectations are firml anchored. that the private sectors assumes that the central bank will make ever effort to return to the natural level of output as soon as possible after a shock has hit the econom. Phillips curve (PC) ( ) ε π =π + d +ε where ε N, σ ME II, Prof. Dr. T. Wollmershäuser, Slide 22

23 Graphical Representation in a r / π Diagram r = a br +ε a 1 1 r = + ε b b b 1 1 r n IS π PC π = π + d + ε 2 π ME II, Prof. Dr. T. Wollmershäuser, Slide 23

24 Monetar Polic in the IS-MP-PC Model Monetar polic stabilizes the econom r ε 1 ε 2 π L Econom without monetar polic L is the social welfare loss, that results from fluctuations of production around its natural level and the inflation rate around the inflation target ME II, Prof. Dr. T. Wollmershäuser, Slide 24

25 Monetar Polic in the IS-MP-PC Model the central banks tries to minimize the social welfare loss (= objective function) its instrument is the short-term nominal interest rate i (the central bank has perfect control over the refinancing costs of banks) given the expected rate of inflation π e = π the central bank can also influence the real interest rate r the objective function is given b t L ( ) 2 2 = π π +λ where < λ < This is a quadratic loss function, which has the important propert of being smmetric: a deviation above the target causes the same loss as the same magnitude of deviation below the target. ME II, Prof. Dr. T. Wollmershäuser, Slide 25

26 Flexible Inflation Targeting optimal monetar polic min L = π π + λ ( ) 2 2 subject to the structure of the econom π = π + d + ε2 = a br +ε1 optimal interest rate opt a 1 d r = + ε + ε b b b d ( 2 +λ) 1 2 ME II, Prof. Dr. T. Wollmershäuser, Slide 26

27 Flexible Inflation Targeting ( ) ( ) L = π π + λ = d+ ε + λ = a br + ε 1 { 2 ( ) } 2 L = d + ε + λ ψ{ a + br ε } 2 1 () 1 L = 2d( d+ ε2 ) + 2λ ψ = ( 2) L r = ψ b = ( 3) L ψ = a+ br ε1 = from ( 2 ): ψ = in ( 1) d then ( 1' ): = ε 2 2 in ( 3) d + λ a 1 d then ( 3' ): r = + ε + b b b d 2 ( + λ ) ε 1 2 ME II, Prof. Dr. T. Wollmershäuser, Slide 27

28 Flexible Inflation Targeting r r = a br +ε 1 a 1 1 r = + ε1 b b b a 1 d r = + ε + ε b b b d 2 ( +λ) 1 2 IS π PC π = π + d + ε 2 π ME II, Prof. Dr. T. Wollmershäuser, Slide 28

29 Flexible Inflation Targeting r r r (ε 1 = ) demand shock (ε 1 < ) π IS PC π ME II, Prof. Dr. T. Wollmershäuser, Slide 29

30 Flexible Inflation Targeting r r r (ε 1 = ) demand shock (ε 1 < ) π IS 1 IS PC π π 1 ME II, Prof. Dr. T. Wollmershäuser, Slide 3 1

31 Flexible Inflation Targeting r r r 1 r (ε 1 = ) r (ε 1 < ) demand shock (ε 1 < ) π IS 1 IS PC π π 1 ME II, Prof. Dr. T. Wollmershäuser, Slide 31 1

32 Flexible Inflation Targeting r r r 1 r (ε 1 = ) r (ε 1 < ) demand shock (ε 1 < ) π IS 1 IS PC π π 1 ME II, Prof. Dr. T. Wollmershäuser, Slide 32 1

33 Flexible Inflation Targeting the central bank can perfectl compensate the demand shock central bank faces no trade-off between inflation and emploment (output) If there was a trade-off between objectives, then a choice between the different goals would have to be made. A trade-off involves a sacrifice that must be made to reach one objective, rather than the other. ME II, Prof. Dr. T. Wollmershäuser, Slide 33

34 Flexible Inflation Targeting r suppl shock (ε 2 > ) r r (ε 2 = ) L ( ) 2 2 π π λ = + IS ( π π ) ( L) ( ) = + ( L λ ) π PC h= L,g = L λ λ output junkie (vertical line) λ= inflation nutter (horizontal line) λ=1 "flexible" IT (circle) π g h ME II, Prof. Dr. T. Wollmershäuser, Slide 34

35 Flexible Inflation Targeting r suppl shock (ε 2 > ) r r (ε 2 = ) IS π PC 1 PC π ME II, Prof. Dr. T. Wollmershäuser, Slide 35

36 Flexible Inflation Targeting r suppl shock (ε 2 > ) r 1 r r (ε 2 >, λ = ) r (ε 2 >, λ ) IS π PC 1 PC π 1 B π A ME II, Prof. Dr. T. Wollmershäuser, Slide 36 1

37 Flexible Inflation Targeting r suppl shock (ε 2 > ) r 1 r 2 r r (ε 2 >, λ = 1) IS π PC 1 PC π 1 2 B π A ME II, Prof. Dr. T. Wollmershäuser, Slide

38 Flexible Inflation Targeting central bank faces a trade-off between inflation and output stabilization optimal polic depends on the objective function and hence the preferences of the central bank ME II, Prof. Dr. T. Wollmershäuser, Slide 38