Actors of Monetary Environment. Monetary Policy. Inflation, the Phillips Curve, and Central Bank Commitment

Transcription

1 Actors of Monetary Environment Inflation, the Phillips Curve, and Central Bank Commitment Mankiw Chapter 13 Williamson Chapter 17 Barro and Gordon (1983) Alesina and Summers (1993) Cukierman et al. (2001) Central Banks Financial Institutions (intermediaries, financial markets) Lender-Savers (firms, government, households, foreigners) Borrower-Spenders (firms, government, households, foreigners) Monetary Policy Responsible for Monetary Policymaking : Central Banks US Fed, ECB, BoE etc. Oldest: Sveriges Riksbank (1656,1668) BoE (1694) 1

2 Monetary Policy Framework Instruments - Reserve Requirements - Official interest Rates - Open Market Operations Operating Targets - Short-term Interest Rate - Reserve Aggregates Intermediate Targets - Monetary Aggregates -Inflation - Exchange Rate Goals - Price stability - Sustainable Growth - High Employment - Financial Stability Tactics Strategy Central Bank Targets (Goals) Can Vary Can be Multiple: Stabilize Inflation Eliminate Output Gap Increase Employment/reduce unemployment Less Volatile Interest Rates Less Volatile Exchange Rates etc. Some of them (or all together!!) Some Hypothetical Central Bank Objective Functions Min E [L t ] = Var[π t -π t *] Min E [L t ] = Var[y t ] Min E [L t ] = Var[π t -π t *]+ λvar[y t ] Min E [L t ] = Var[π t -π t *]+ λvar[y t ]+ δvar[ i t ] Min E [L t ] = Var[π t -π t *]+ λvar[ue t ]+ δvar[ i t ] Monetary Policy Very difficult task Multiple objectives, usually one operating target (interest rates or a monetary aggregate) to reach this objectives Even worse.. There may be conflicting objectives of the Central Banks and other economic or political institutions Central Bank constitution may be very important Time inconsistency Phillips Curve (or AS Curve) tells you that there may be trade-offs between inflation and output/unemployment Lack of credibility may impart an inflation bias to monetary policy. This lack of credibility results from the time inconsistency problem faced by policy announcements: a policy that is optimal ex ante may no longer be optimal ex post. Reason: policymakers are concerned about inflation as a policy goal and with the fact that inflation may carry benefits. 2

3 Time inconsistency problem problem: the idea that inflation results from a game played between the government and the general public. Central Banks have an incentive to cheat if there is no binding commitment Credibility Time inconsistency Public will deduce that inflation targets will not be met and thus raise their inflation expectations accordingly - which will itself increase inflation and make the announced inflation target redundant. Policy implication: in order to control inflation, Central Banks should be bound by externally-imposed rules or run by conservative chairman. Binding commitments in the charters of central banks in several countries: central bank independence Central Bank Independence (CBI) Alesina & Summers (1993) CBI & Inflation Characterization and measuring CBI is difficult Legal, institutional, cultural and personal factors all play a role Main idea is to have a CB that does not share identical time preferences as concerns the stabilization of business cycle and inflation as the politicians.. CBI & Inflation CBI & Real Output 3

4 CBI & Real Output Central Bank Independence and Macro Performance in 17 Countries Monetary Policy Process: Central Bank Independence problem: the idea that inflation results from a game played between the government and the general public. (Barro and Gordon (1983)) Central Banks have an incentive to cheat if there is no binding commitment Credibility Time inconsistency Lack of credibility may impart an inflation bias to monetary policy. This lack of credibility results from the time inconsistency problem faced by policy announcements: a policy that is optimal ex ante may no longer be optimal ex post. Reason: policymakers are concerned about inflation as a policy goal and with the fact that inflation may carry benefits. Some policymakers may want private agents to expect low inflation, in order to exploit a favorable trade-off between inflation and output. But the mere announcement of a policy of low inflation is not credible, because policymakers have an incentive to renege to increase output and reduce unemployment and private agents understand this renege. Result: inflation will in equilibrium be higher than it would be otherwise; monetary policy suffers from an inflation bias. 4

5 Time inconsistency Public will deduce that inflation targets will not be met and thus raise their inflation expectations accordingly - which will itself increase inflation and make the announced inflation target redundant. Credible commitment to a policy rule is welfare enhancing compared with a discretionary policy. If policymakers can credibly commit themselves to low inflation, the economy will be better off; output will be the same as in the discretionary policy case but inflation will be lower. Policy implication: in order to control inflation, Central Banks should be bound by externally-imposed rules or run by conservative chairman. Binding commitments in the charters of central banks in several countries Central Bank Independence Factors making BoE independent 1. Insrument independence: BoE can set SR interest rates 2. Inflation is the target Factors making BoE dependent 1. Political process determines the inflation target Overall: BoE is quite independent Other Central Banks 1. European Central Bank: most independent price stability primary goal 2. Bank of Canada and Japan: fair degree of independence, but not all on paper 3. US Fed: Fed is financially independent; however Congress can amend Fed legislation;president appoints Chairmen and Board members and can influence legislation Alesina & Summers (1993) CBI & Inflation CBI & Inflation CBI & Real Output 5

6 CBI & Real Output Central Bank Independence and Macro Performance in 17 Countries Some Early Results There seems to be some relationship between the CB independence and inflation stabilization No relationship between CBI and output Major question: Is this causal relationship (structural versus reduced form) CBI in Transition Economies Cukierman, Miller, Neyapti (JME, 2002) Study based on CEE and Ex-Soviet Republics Interesting since all those countries created or updated their CBs in 8y time May give an idea about causality btw CBI and inflation 6

7 Estimation Cross section time series evidence D: inflation proxied by real depreciation of money CLI: Cumulative liberalization index I: price decontrols WD: war dummies DCB: currency board dummy LVAW, LVES, LVESX: CBI indices Estimation Cukierman et al. (2002) D=f(CLI, I, WD, LVAW, DCB) 7

8 Cukierman et al. (2002) Transition economies Not a clear cut case Without other structural changes in the economy Central Bank independence (CBI) is not necessarily sufficient to achieve price stability However, international evidence suggest that there is a correlation (not necessarily a causation) between inflation stabilization and CBI Case For: Should a CB be Independent? 1. Independent CB likely has longer-run objectives, politicians don't: evidence is better policy outcomes 2. Avoids political business cycle 3. Less likely deficits will be inflationary Case Against: 1. CB may not be accountable 2. Hinders coordination of monetary and fiscal policy 3. Without deeper structural changes in the economy unlikely to be too successful Conclusions Time inconsistency problem Inflationary bias Independent CBs tend to perform better in achieving lower inflation Independence alone may not be sufficient to design a credible monetary policy Reputation Next week: Formally derive the time inconsistency problem 8