Lecture 8: Inflation and Monetary Policy

Transcription

1 Lecture 8: Inflation and Monetary Policy

2 INFLATION

3 IS INFLATION BAD OR GOOD? Think of pensioners or others whose income is fixed in nominal terms. Why would inflation be bad for them? People with nominal debt will benefit from inflation People with nominal assets will lose Really high inflation (called hyperinflation) can effectively wipe out the value of someone s savings or assets. Inflation can thus be seen as a redistribution from creditors to debtors

4 IS INFLATION BAD OR GOOD? Real Interest Rate : The interest rate corrected for inflation (that is, the nominal interest rate minus the rate of inflation). While there is no evidence that moderate inflation is bad for the economy, when inflation is high it is often volatile. Large price changes can create uncertainty, which will spook investors and business owners, and make it difficult for people to plan for retirement, set up savings, etc.

5 HYPERINFLATION Hyperinflation undermines the very basis of capitalism, by turning market prices into meaningless noises. - Ha-Joon Chang

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8 IS INFLATION REALLY SO BAD? Despite fairly wide consensus among economists that inflation beyond a low level (2-3%) is bad, the evidence is not so clear. Consider the following: A study by Robert Barro, now at Harvard, suggests that below 10%, inflation has no effect on growth, and between 10-20% has only very mild negative effects Another study by an IMF economist found that below 8%, inflation is generally good for the economy, though mildly so Studies by William Easterly and Michael Bruno suggest that the threshold past which inflation becomes bad for an economy might be as high as 20 or even 40 percent During the 60s and 70s Brazil had an average inflation rate of about 42%, but its per capita income was growing at 4.5% per year. You see a similar pattern with South Korea in the same era, though with inflation more around 20%

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10 MODERATE INFLATION Why do many economists think that a little bit of inflation is a good thing? With rising prices, a fall in real income may be masked by the fact that nominal incomes are rising or at least not falling. As it s often put, inflation greases the wheels of the labor market. Inflation also gives monetary policy more room to maneuver

11 IS DEFLATION BAD OR GOOD? Would households and firms be better off with falling prices? Deflation benefits creditors. There is thus a redistribution from debtors to creditors. This can make it very costly to borrow money, which in turn dampens spending by both businesses and individuals. With deflation, households will also postpone consumption because they expect goods will be cheaper in the future.

12 WHAT CAUSES INFLATION? Higher cost of production Higher prices Less competitive markets Rise in the nominal wage Fall in the real wage

13 WHAT CAUSES INFLATION? Higher cost of production Higher prices Rise in the real wage Rise in the nominal wage Fall in the real wage Increased worker bargaining power

14 WHAT CAUSES INFLATION? Higher cost of production Higher prices Rise in the real wage Expected inflation Rise in the nominal wage Fall in the real wage Increased worker bargaining power

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19 MONETARY POLICY Many central banks around the world have policies to target an inflation rate of 2%. They either set this objective for themselves, or the government sets the objective for them. Monetary policy relies on the central bank being able to control interest rates, and on changes in interest rates influencing aggregate demand.

20 MONETARY POLICY Expansionary monetary policy Lower interest rates Investment and consumption encouraged Aggregate demand rises Equilibrium GDP Rises

21 MONETARY POLICY There are two important limitations to monetary policy: 1. The short-term nominal interest rate cannot go below zero This is called the zero lower bound This supposed limitation has been broken recently, with a number of countries actually implementing nominally negative interest rates. Real interest rates have dipped below zero a number of times after the recession.

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23 MONETARY POLICY There are two important limitations to monetary policy: 2. A country without its own currency does not have its own monetary policy. Members of the Eurozone, for example, gave up their own monetary policy when they joined the currency union. Individual US states can t engage in monetary policy Common currency area : A group of countries that use the same currency. This means there is just one monetary policy for the group.

24 MONETARY POLICY

25 INFLATION-TARGETING POLICY Two important features of the 1990s and 2000s prior to the crisis: 1.Central banks were made independent of government control 2.Inflation Targeting

26 INFLATION-TARGETING POLICY

27 THE FEDERAL RESERVE Central bank of the United States Created in 1913 after the Panic of 1907 Sets reserve requirements Acts as a lender of last resort in a crisis Helps to stabilize exchange rates Generally given a lot of power to regulate and supervise banks Via Dodd-Frank, was given the task of systemic risk regulator By law is supposed to maintain stable prices and maximum employment Funds itself via the proceeds of its substantial assets. Whatever earnings are left over after expenses are given back to the US Treasury. (In 2012, they gave back $88 billion.)

28 THE FEDERAL RESERVE

29 THE FEDERAL RESERVE Appointed for nonrenewable 14-year terms. The Chair is appointed for renewable four-year terms.

30 THE FEDERAL RESERVE Legally, the Reserve Banks are private corporations (sort of) Class A directors are stockholder bankers selected by the stockholder banks Class B are non-bankers chosen by stockholder banks Class C are non-bankers chosen by the Board of Governors Since Dodd-Frank, only Class B and C elect the bank president

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32 THE FEDERAL RESERVE Most importantly, remember that the Fed is a they, not an it The salaries of many of the senior staffers, almost entirely economists, is higher than the governors Some ex-governors have even commented that, to a large extent, the governors work for the staff, and not the other way around Fed lawyers don t just interpret law but effectively make policy The whole function of bank supervision is housed within the most opaque part of the Fed System, namely the Federal Reserve Banks