Monetary policy and models

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1 Monetary policy and models Kjersti Haugland and Kjersti Haare Morka Monetary Policy University of Copenhagen, May 7 Consumer prices and money supply Annual percentage growth. -year moving average Growth in money supply Inflation Sources: Statistics Norway and

2 Consumer prices and gross domestic product Annual percentage growth. -year moving average Inflation GDP-growth Sources: Statistics Norway and What can monetary policy determine in the long run? Over time, monetary policy determines the average level of inflation Output is determined by the supply of labour, capital and technology

3 Monetary policy can contribute to smoothing cyclical fluctuations in the short to medium term Actual and trend GDP. Mainland Norway. Billions NOK. 98- ) Output gap Trend GDP Actual GDP Output gap. Percentage deviation between actual and trend GDP. 98- ) ) Projection for Sources: Statistics Norway and Monetary policy in Norway The Government has defined an inflation target for monetary policy in Norway The operational target is consumer price inflation of close to, per cent over time 6

4 Want to influence expectations Monetary policy is management of expectations For not only do expectations about policy matter, but ( ) very little else matters [T]he current level of the overnight interest rates as such is of negligible importance for economic decision-making (Woodford ) 7 How do changes in the interest rate affect the economy? Exchange rate Imported inflation Norges Bank s key rate Market interest rates Inflation expectations Inflation Consumption Investments Labour market Wage growth Margins 8

5 Flexible inflation targeting - theory Loss function: L = (π π * ) + λ(y y*) Flexible: λ > Strict: λ = 9 Output gap and CPI-ATE CPI-ATE - Output gap Sources: Statistics Norway and

6 Output gap and CPI-ATE Strict CPI-ATE - Output gap Sources: Statistics Norway and Output gap and CPI-ATE Strict Flexible CPI-ATE - Output gap Sources: Statistics Norway and 6

7 Flexible inflation targeting Provides the economy with a nominal anchor Allows monetary policy to smooth fluctuations in output and employment Role of the central bank: Bring the economy back to steady state! 6 Real interest rate Interval for neutral real interest rate? CPI-ATE Output gap?? Inflation target Balanced output

8 Constant Interest Rate Movie Monetary Policy Projections in MPR /7 with uncertainty fans Per cent. Quarterly figures. Q Q 9 8 Key policy rate CPI % % 7% 9% CPI-ATE - Output gap Sources: Statistics Norway and 8

9 Models are used for. Analysis of the current economic situation and identification of shocks. Projections. Policy analysis and analysis of risks and uncertainty. Communication The aim is as much to understand the economics of the projections as to produce quantitative estimates (BoE, March ) Models in Model a NEMO Various smaller models 6 9

10 Build the model on the blackboard 7 Model a Output gap Depends on Interest rate (short and long) Exchange rate Growth abroad Exogenous shocks 8

11 Model a Inflation Depends on Inflation expectations (previous, future, target) Output gap Exchange rate and prices abroad Exogenous shocks 9 Model a Exchange rate qgap t = γ E t qgap t+ -[(rm t -r*) -(rm_f t - r_f*)]/ + ε q () Depends on Exchange rate expectations Interest rate differential Exogenous shocks

12 Model a Interest rate - reaction function i = αi - + (-α)[β (π i -π * )+β (y)+β (y-y - )]. Aggressiveness inflation, β. Aggressiveness output gap, β. Aggressiveness change output gap, β. Response horizon, π i. Interest rate smoothing, α Go live