Understanding the World Economy Master in Economics and Business. Monetary policy. Nicolas Coeurdacier

Transcription

1 Understanding the World Economy Master in Economics and Business Monetary policy Lecture 8 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr

2 Lecture 8 : Monetary policy 1. What is monetary policy? 2. Inflation output trade off 3. Monetary policy in practice 4. Great recession: new policy tools

3 Whatismonetarypolicy? SetbytheCentralBank A Central Bank; institution that has the responsibility for the amountof moneyandcreditintheeconomy Instruments: interest rate rather than Monetary Base -- Federal Reserve US: federal funds rate(ffr) -- ECB -- euro area rate on main refinancing operation(mro) These are rates on overnight interbank market. Targets: inflation or other

4 Whatismonetarypolicy? Targets Fed: dualmandate ECB: price stability BoE: 2%inflation In principle no inconsistency between price stability in long run and natural rate of unemployment... But only in the long run. Strategies Fed:justdoit ECB: two pillars BoE: inflation report

5 Whatismonetarypolicy? Operational = instrument almost always interest rates Intermediate = targets money supply, credit, exchange rate, inflation forecast Final objectives = inflation, output

6 Federal Funds Rate (%, ) Source: Fed Saint Louis (FRED)

7 Whatdoesmonetarypolicy? For simplicity, assume that a monetary expansion stimulates aggregate demand in the short run. By lowering the target interest rate, the Central Bank stimulate borrowing by firms and consumers. This in turn stimulates aggregate investment and consumption and thus output. Other potential channels of transmission that we will explore later.

8 Monetary policy and aggregate demand Prices Aggregate Demand Curve Short Run Supply Curve Monetary expansion Output

9 Lecture 8 : Monetary policy 1. What is monetary policy? 2. Inflation output trade off 3. Monetary policy in practice 4. Great recession: new policy tools

10 Inflation over the business cycle Over the business cycle, there is a positive correlation between inflation and output - When output growing fast inflationary pressures are strong - Conversely when output growth is negative and the economy is in recession, inflationary pressures low This relationship between inflation and unemployment is called the Phillips Curve and has a key role in the macroeconomics of stabilisation policy

11 The Phillips curve Inflation A B Unemployment

12 The Phillips curve U.S. ( )

13 The Phillips curve U.S. ( )

14 Why the Phillips curve? Prices in the short run do not adjust continuously. Short run aggregate supply curve slopes up. Policies (or any shocks) that stimulate aggregate demand increase output and increase prices. Thus, unemployment and inflation are negatively related. This is the Phillips Curve

15 Why the Phillips curve? Prices Aggregate Demand Curve Short Run Supply Curve Output

16 The Phillips curve a guide for policy? The Phillips curve: A menu of choices for governments? (a) unemployment too high? Set policy to achievepoint A-the cost is higher inflation (b) Inflation too high? Set policy to achieve point B- cost is higher unemployment Thus there is a trade-off: less inflation possible but only at the cost of more unemployment

17 Expectations and the Phillips curve In the 1950s and 60s: Governments perceived the Phillips curve trade-off and it was an important influence on economic policy Milton Friedman and Ned Phelps: No exploitable trade-off - The Phillips curve depends on agents expectations of inflation. - Increases in inflation expectations shift the Phillips curve upwards. - Phillips curve is not a menu of choices: If government attempts to lower unemployment by increasing inflation, expectations will adjust and only end product is higher inflation.

18 The Phillips curve Inflation A E =Inflation Expectations B Unemployment Inflation is equal to expectations of inflation when unemployment equals its natural rate. ishigher than expectationswhenlow and islower than expectationswhenishigh.

19 The Phillips curve Keeping the same notations, can represent the Phillips curve as : = + With = Natural Rate of Unemployment Example:Let =0.5and =6% If everyone thinks inflation is going to be 5% and actual inflation is 5% then unemployment is 6%. Butifunemploymentis2%,inflationis7%(= )

20 Justification for the Phillips curve Pricesandwagesdonotvarycontinuouslyfromdaytoday - Instead they are set for a period of time and only periodically reviewed. - For instance, wages are often negotiated on a yearly basis and once set can only be changed with difficulty. Unexpectedly high inflation: Lowers real wages and therefore leads to increased labour demand and lower unemployment. Unexpectedly low inflation: increases unemployment.

21 Natural rate of unemployment Inflation [P.C (2%) denotes Phillips Curve based on 2% inflation expectations] 6% D E 4% 2% B C A P.C (6%) P.C (4%) natural rate P.C (2%) Unemployment

22 Theimportanceofexpectations Initially at point A, expected inflation E = actual inflation, unemploymentrate=naturalrate ; Government inflates the economy to lower unemployment at point B. But economy will not stay at point B. Expected inflation will rise from 2% to 4%:thePhillips curveshifts upandtheeconomythenmoves to pointc. At point C the government again inflates and sets inflation to 6%. Once again inflation expectations rise as does the Phillips curve and economy moves to pointe.. Therefore the government has made no lasting reduction in unemployment and has simply produced more inflation Adjustments might take time but while you can fool someone sometimes, you cannot fool everybody all the time.

23 The seventies and the Phillips curve Friedman and companions initially dismissed - but their prediction was exactly what happened later. In the 1970s: The Phillips curve became inoperable for policy purposes. Inflation expectations soared but unemployment remained high (stagflation). High levels of inflation led agents to revise their expectations frequently. Crucial insight: Nominal variables, such as money, cannot determine in the long run real variables such as output and unemployment.

24 The Phillips curve has shifted over time

25 Credibilityandtimeconsistency As a result of this governments can benefit from credibility. Credibility is where the government can be trusted to act in the way it has previously announced it would. But if not, then time inconsistency Our example of the Phillips curve shows how what agents think will happen in the future has an important influence on today s events- a recurrent theme in economics.

26 Rulesvs.Discretion Commitment device: Promise not to use discretionary policy -in the Phillips curve example always use a rule which aims for 2% inflation. By denying itself certain options the government can achieve better outcome. Superiority of rules is now a consensus view, because: (1) easy to understand. (2) give control to someone else who acts in self interest to avoid credibility problem.

27 Can government do anything about it? Source: Alesina& Summers( data)

28 Lecture 8 : Monetary policy 1. What is monetary policy? 2. Inflation output trade off 3. Monetary policy in practice 4. Great recession: new policy tools

29 HowdoestheCB controlthemb? 1. Open Market Operations(OMO) Central Banks BUY(SELL) government bonds increase(decrease) in monetary base 2. Discount loans to banks Standing lending facilities -- primary credit: source of liquidity for healthy banks -- secondary credits: for banks in trouble Also lender of last resorts

30 Monetarypolicyinpractice a) The Central Bank does not control money in circulation (remember the multiplier) b) By changing monetary base through open market operations affects the very short term interest rate (on interbank markets) =rateatwhichbankborrowandlendtoeachotherovernight Open Market Purchase: Federal Funds Rate Open Market Sale: Federal Funds Rate c) Notonlyone interestrate! d) monetary transmission mechanism: how interest rate affect the economy

31 Policy rate and market rates OFFICIAL RATES So what we need is to know how: MARKET RATES Policy makers do NOT determine the market rates (the rate at which you can borrow, the interest you receive). But, they directly affect: (1)therateat whichbankscanborrowliquidity fromthecb; (2) the rate at which Banks can borrow and lend liquidity between themselves These rates determine the costs of obtaining liquidity for financial institutions which in turn determine the rate at which Banks borrow and lend to their customers (i.e. the market rate) For monetary policy to be effective, need market rates to move with the official rate.

32 Percent U.S. interest rates ( ) 3 month treasury bill Corporate BAA bonds US Government Long term bonds Federal funds rate LIBOR 3 month (US)

33 Market Rates Monetary Policy Transmission Asset Prices (incl. exchange rate) Domestic Demand Domestic Inflationary Pressure Official Rate Aggregate Demand Inflation Exchange Rate Expectations/ Confidence Net External Demand Import Prices

34 Effectsofmonetarypolicy shocks Empirical question, need to take into account: (a) many endogenous movements in monetary policy variables - we re interested in how a change in monetary policy stance affects the economy - not in the response of the CB to the stance of the economy. (b) that there are time lags in how monetary policy affects the economy.

35 percentage change 1,0 0,8 0,6 0,4 0,2 0,0-0,2-0,4-0,6 Effect of Monetary Policy in the US Source: Christiano, Eichenbaum and Evans quarters after monetary contraction Target Rate M1 percent 0,2 0-0,2-0,4-0,6-0, quarters after monetary contraction GNP Unemployment Prices Monetary Contraction (0.75% exogenous increase in target rate), lowers money supply, output and prices, and increases unemployment.

36 Inflationstabilizingrules A stylized description of US monetary policy The Taylor Rule: = + π π +μ ( y ) The Central Bank increases the interest rate when inflation is high and when output is above potential. Important to have >. Why? Output gap A more conservative Central Bank puts more weight on price stability (high relative to μ). A more accommodative Central Bank puts more weight on output (higher μ). A good approximation of the U.S. data is: 1.5and 0.5

37 Taylor Rule Effective Fed Fund Rate

38 Taylor Rule exported in Germany Source: Sauer and Sturm (2003)

39 Inflationstabilizingrules = + π π +μ ( y ) Output gap The Taylor Rule is an approximation of the behaviour of the Fed (reality more complex). Variations on this rule also work relatively well as descriptions of monetary policy also in Europe. A key feature of the Taylor rule is that real interest rates rise in order to reduce inflation. If interest rates increase merely in line with inflation then not really contractionary monetary policy real interest rate unchanged.

40 Inflation and real interest rate

41 Can youchair the Fed?

42 Lecture 8 : Monetary policy 1. What is monetary policy? 2. Inflation output trade off 3. Monetary policy in practice 4. Great recession: new policy tools

43 Themonetaryresponsetothelastcrisis Standard response: Cut policy interest rates substantially Non-standard responses: Acted to prevent a complete collapse of the financial system Through central bank intermediation, maintained inter-bank transactions.

44 Policy response: interest rate

45 ZeroLowerBound Central Bank would like to lower nominal rate as economy is very weak, but impossible to go below zero=zero LowerBound (ZLB) Standard monetary policy runs its course when the base ratehits the ZLB. Switch to non-standard monetary policy: credit easing or quantitative easing (balance sheet expansion of the Central Bank).

46 Ben Bernanke (13 th January 2009) The Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds.

47 Fed balance sheet after credit easing Assets Government securities Discount Loans Gold Commercial Papers AIG, TAF, AMLF Liabilities Currency in circulation Banks reserves Non-standard instruments AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; TAF: Term Auction Facility

48 Federal Reserve assets

49 Is credit easing inflationary? No, as long as credit does not find its way in the economy and the economy is very weak. Banks are hoarding cash; so are companies. Large increase in liquidity (in base money ) does not lead immediately to a corresponding increase in credit. Velocity of money has fallen in the US during the Great recession. Reminiscent of the Great Depression.

50 Circulation of money slows down: cash hoarding

51 Unwindingcrediteasing Central Banks should not unwind too soon (Fed tightened too early in the Great Depression). But inflationary expectations may increase (lot of liquidity may find its way in the economy if velocity increases). Delicate balance to achieve. Conflicting objectives: speed up recovery versus price stability.

52 Summary Monetary policy conducted by CBs, which tradeoffsinflation and unemployment in the short-run. CBs controls the short-term policy rate through open market operations which change the monetary base. The policy rate affects other rates and transmits with lags to the rest of the aggregate economy through various channels. The Taylor rule describes CB best practice in normal times. In exceptional time, when interest rate is at zero or near zero, monetary policy can use other tools such as liquidity provision.