Monetary Policy Theory Monetary Policy Analysis Monetary Policy Implementation. Monetary Policy. Bilgin Bari
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1 Theory Analysis Implementation
2 Theory Analysis Implementation AD-AS analysis is a powerful tool for studying short-run fluctuations in the macroeconomy. We can analyze how aggregate output and inflation rate are determined in the short-run.
3 Theory Analysis Implementation 1 Theory and Aggregate Demand and Interest Rate Rule 2 Analysis The Objectives of Analyzing Policy Effects 3 Implementation Tools of Causes of Inflationary
4 Theory Analysis Implementation The Aggregate Demand and Aggregate Demand and Interest Rate Rule 1 Y = [ C + Ī + Ḡ + NX (mpc T )] c + d + x 1 mpc 1 mpc r }{{}}{{} The equation shows how to determine aggregate output when goods market is in equilibrium. It shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium. First component of the equation explains demand shocks. Second component of the equation explains policy shocks.
5 Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule Central Banks use a very short-term interest rate as their primary policy tool. The interest rate is overnight interest rate at which banks lend to each other. We need real interest rate : r = i π e - changes in nominal interest rate changes in real interest rate (only if actual and expected inflation remain unchanged in the short-run) - We know prices are sticky in the short-run. Central bank can determine the real interest rate in the short-run.
6 MP Curve I Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule MP curve indicates the relationship between the real interest rate which central bank sets and the inflation rate. r = r + λπ MP has an upward slope : - Policy makers follow Taylor principle to stabilise inflation. - Interest rate is raised more than any rise in expected inflation. - Real interest rate rise if there is a rise in inflation.
7 MP Curve II Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule
8 Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule The Taylor Rule I Taylor rule was invented by John Taylor, a Stanford economist, outlined the rule in his precedent-setting 1993 study Discretion vs. Policy Rules in Practice. It s a proposed guideline for how central banks should alter interest rates in response to changes in economic conditions. It s a forecasting model used to determine what interest rates will, or should, be as shifts in the economy occur. It makes the recommendation that the central bank should - raise interest rates when inflation is high or when employment exceeds full employment levels. - decrease interest rate when inflation and employment levels are low.
9 The Taylor Rule II Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule Real federal funds rate : r = (π π T ) + 0.5(Y Y P ) Nominal federal funds rate : i = π (π π T ) + 0.5(Y Y P )
10 The Taylor Rule III Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule Example : Long-term GDP growth : 2.5 % Current GDP growth : 3.5 % Inflation target : 2.0 % Current inflation : 4 % i = 3% + 2.0% + 0.5(4% 2%) + 0.5(3.5% 2.5%) 6.5% = 3% + 2.0% + 0.5(2%) + 0.5(1%)
11 The Taylor Rule IV Theory Analysis Implementation and Aggregate Demand and Interest Rate Rule
12 Theory Analysis Implementation The Objectives of Analyzing Policy Effects The Policy Objectives There are two primary objectives: Stabilizing economic activity Achieving natural rate of unemployment is equivalent to stabilizing the economy. At the natural level of unemployment, the economy moves to its natural level of output, which we refer to more commonly as potential output. Minimizing output gap: Y Yp Stabilizing inflation around a low level Price stability Maintanig inflation (π) close to a target level (π T ) Minimizing inflation gap: π π T Loss Function: L = α(π π T ) 2 + (1 α)(y Y p ) 2
13 Theory Analysis Implementation Aggregate Demand Shock The Objectives of Analyzing Policy Effects Aggregate demand shock: policy stabilize output in the short-run
14 Theory Analysis Implementation Aggregate Supply Shock The Objectives of Analyzing Policy Effects Aggregate supply shock: policy stabilize inflation in the short-run
15 Theory Analysis Implementation Aggregate Supply Shock The Objectives of Analyzing Policy Effects Aggregate supply shock: policy stabilize output in the short-run
16 Theory Analysis Implementation The Objectives of Analyzing Policy Effects Policy Results For demand shocks, policy that stabilizes inflation will also stabilize economic activity. The Divine Coincidence : stabilizing inflation also stabilize output. For supply shocks, central bank must choose between the two objectives. There is trade-off for the supply shocks.
17 Theory Analysis Implementation Lags and Policy Implementation Tools of Causes of Inflationary The data leg: It is the time it takes for policymakers to obtain the data that describe what is happening in the economy. The recognition lag: It is the time it takes for policymakers to feel confident about the signals the data are sending about the future course of the economy. The legislative lag: It is the time it takes to get legislation passed to implement a particular policy. The implementation lag: It is the time it takes for policymakers to change policy instruments once they have decided on a new policy. The effectiveness lag: It is the time it takes for the policy to have real impact on the economy.
18 Theory Analysis Implementation Tools of Causes of Inflationary Transmission Mechanism of
19 Theory Analysis Implementation Equilibrium in the Market for Reserves Tools of Causes of Inflationary
20 Theory Analysis Implementation Tools of Causes of Inflationary Demand and Supply in the Market for Reserves The demand for reserves Required reserves : required reserve ratio x the amount of deposits Excess reserves : the additional reserves banks choose to hold. Opportunity cost of holding excess reserves is the interest rate. The supply for reserves Nonborrowed reserves (NBR): the amount of reserves that are supplied by open market operations. Borrowed reserves (BR): The amount of reserves borrowed from the central bank.
21 Theory Analysis Implementation Tools Tools of Causes of Inflationary Open Market Operations Open market purchases expand reserves and the monetary base, increasing money supply and lowering short-term interest rates. Open market sales shrink reserves and the monetary base, decreasing money supply and raising short-term interest rates. Discount policy The facility at which banks can borrow reserves form the central bank. The central bank change the discount rate. Reserve Requirements Changes in reserve requirements affects the money supply by causing the money supply multiplier to change. A rise in reserve requirements increases the demand for reserves and raises the interest rate.
22 Theory Analysis Implementation The Interest Rate Corridor Tools of Causes of Inflationary
23 Theory Analysis Implementation The Interest Rate Corridor Tools of Causes of Inflationary
24 Cost-Push Inflation Theory Analysis Implementation Tools of Causes of Inflationary results either from a temporary negative supply shock or a push by workers for wage hikes beyond what productivity gains can justify.
25 Theory Analysis Implementation Demand Pull Inflation Tools of Causes of Inflationary results from policy makers pursuing policies that increase aggregate demand.
26 Turkey data Theory Analysis Implementation Tools of Causes of Inflationary
27 Turkey data Theory Analysis Implementation Tools of Causes of Inflationary
28 Price Stability Theory Analysis Implementation Tools of Causes of Inflationary Price stability is so crucial to the long-term health of an economy. Low and stable inflation rates promotes economic growth in the long-run Inflation target gives net signals to economic agents. Risk premium of investment instruments and interest rate falls Sustainable economic growth and employment are experienced. A central element in successful monetary policy is price stability.
29 Inflation Targeting Theory Analysis Implementation Tools of Causes of Inflationary Public announcement of medium-term numerical objectives (targets) for inflation. An institutional commitment to price stability as the primary goal of monetary policy and a commitment to achieving the inflation goal. Inflation target gives net signals to economic agents. Increased transparency of the monetary policy strategy. Increased accountability of the central bank for attaining its inflation objectives.
30 Turkey data Theory Analysis Implementation Tools of Causes of Inflationary
31 Turkey data Theory Analysis Implementation Tools of Causes of Inflationary
32 Turkey data Theory Analysis Implementation Tools of Causes of Inflationary
33 Theory Analysis Implementation Pros and Cons of Inflation Targeting Tools of Causes of Inflationary Inflation targeting can reduce political pressures on the central bank to pursue inflationary monetary policy and thereby reduce the likelihood of the time-inconsistency problem. Inflation targeting has the advantage that it is readily understood by the public and is thus highly transparent.(communication policy) Transparency and communication go hand in hand with increased accountability. Inflation targeting promotes the accountability of the central bank to elected officials. Inflation targeting countries seem to have significantly reduced both the rate of inflation and inflation expectations. Inflation nutter polices lead to large output fluctuations.
34 Theory Analysis Implementation Tools of Causes of Inflationary Prerequisites for The Inflation Targeting Regime Strict commitment to price stability Independent, accountable and reliable the central bank Strong and advanced financial markets Low fiscal dominance Providing technical infrastructure
35 Theory Analysis Implementation Tools of Causes of Inflationary Implementation of Inflation Targeting in Target setting (central bank / government) Target variable (CPI / core inflation) Point or band target Target horizon Decision-making mechanism Accountability Communication policy
36 Theory Analysis Implementation Tools of Causes of Inflationary Implementation of Inflation Targeting in Turkey I The government and CBRT set inflation target together. Target variable is CPI. In case of deviations from the target, the causes of the deviation and measures to be taken are report to Government and announced to the public. The target horizon is the middle term. Three-year targets are declared. Decisions on short-term interest rates are voted by monetary policy committee. Meetings are held regularly every month. The CBRT s main communication tool is the quarterly Inflation Report.
37 Theory Analysis Implementation Tools of Causes of Inflationary Implementation of Inflation Targeting in Turkey II MPC meeting summaries are another communication tool. Within the scope of accountability, CBRT - provides a report to the Council of Ministers in April and October each year, - notifies the TBMM Planning and Budget Commission twice a year.
38 Theory Analysis Implementation Tools of Causes of Inflationary Inflation Report
39 References Theory Analysis Implementation Tools of Causes of Inflationary Mishkin, Macroeconomics: Policy and Practice, Chapter 13
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