Principles of Banking (III): Macroeconomics of Banking (1) Jin Cao (Norges Bank Research, Oslo & CESifo, München)
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Disclaimer (If they care about what I say,) the views expressed in this manuscript are those of the author s and should not be attributed to Norges Bank.
The macro side of banking As we have already known, banking system is the artery of modern economy, channeling funds into real economy. This leads to two implications on studying the macro side of banking: 1 The state may intervene the real economy through banking sector, via conducting monetary policy through central banking; 2 The frictions in banking system may amplify volatilities in real economy, even make the entire economy implode: macro-finance linkages.
(Conventional) monetary policy in central banking In a modern economy, central bank the bank of all banks is established to stabilize the macroeconomy, through implementing monetary policy via monetary instruments; It usually has clear mandates, and is independent for better achieving the mandates; It usually has clear targets for monetary policy, as indicators for stable macroeconomy; It usually use interest rates instruments to shift banks cost of funding, hence money supply, or, banks aggregate credit supply, to affect real economy; We focus on transmission machanisms, i.e., how monetary policy affects aggregate demand and real economy through banking sector. institution-logo-filen
Unconventional monetary policy (of Fed) during turmoil However, in crises conventional monetary instruments often cease to work Conduits in banking get clogged, need to be cleaned up and get restarted; Conventional monetary instruments often soon reach limits and cannot be pushed further; We take Fed as an example of a central bank in crisis mode to show How monetary policy effectively reduces banks funding cost and restarts the banking system; How central bank takes over failing market and pulls the economy out of the crisis. institution-logo-filen
Unconventional monetary policy in Europe European Central Bank (ECB) has been facing similar problems as Fed, while in addition subject to severe sovereign debt issues. (Framing the unconventional monetary policies conducted by ECB since 2007 is left as your exercises)
Why monetary policy has real impact? The most fundamental question in central banking is: why is monetary policy able to move real economy? What central bank controls is fiat money; it doesn t directly mobilize real resources in the economy; Thought experiment: suppose central bank doubles its money base. If price level doubles, too, the purchasing power of money will be unchanged no real impact; Therefore, if monetary policy does have real impact, there must be (nominal / real / financial / behavioral) frictions or imperfections preventing the prices from going hand-in-hand with monetary disturbances.
Frictions: Evil is the root of all money Price Stickiness: firms may not adjust prices immediately after monetary shocks; Wage rigidity: price of labor doesn t change frequently; Matching inefficiency: imperfection in matching between labor and vacancies; Capital adjustment cost: firms can only change capital stock at a cost; Credit constraints: frictions in financial sector hinders efficient allocation of credit; Habit: consumers are reluctant to deviate from favorite consumption bundles;... institution-logo-filen
Price stickiness: an example of nominal rigidity A well known example of such frictions is price stickiness: Observation: markets are far from perfect competition; they are at most monopolistic competitive (because of product differentiation, transaction cost, etc); Result: market power allows firms to charge higher price than marginal cost; natural rate of output is lower than economy s full capacity; Price stickiness: firms may not adjust prices after every monetary shock. Therefore, monetary shocks may shift aggregate demand.
Equilibrium under monopolistic competition To see how price stickiness arises, suppose the economy is populated with monopolistic firms who face a downward sloping demand curve D. Price D MC p A E MR q Quantity institution-logo-filen
Equilibrium under monopolistic competition Under monopolistic competition A firm chooses the output q to maximize its profit, when the marginal revenue equals marginal cost (MR = MC); As a result, equilibrium price p is higher than MC mark up = AE; And the natural rate of output q is below the level under perfect competition. Imperction that distorts efficient allocation.
Flexible price adjustment under demand shock Price D D MC p p B A MR MR q q Quantity
Price adjustment under demand shock Suppose a negative demand shock shifts D to D and MR to MR If price is flexible, profit maximizing firms will adjust p to p to make MR = MC; And cut down output to q ; However, if they stay with (p, q ) instead of shifting to (p, q ) The loss in profit (red triangle) is rather small; A small cost in price adjustment ( menu cost ) is enough to prevent price change sticky price.
Menu cost and sticky price Price D D MC p p C B A MR MR q q q Quantity
Real impact of monetary policy under sticky prices With price stickiness, firms only adjust prices under big monetary shocks, or adjust infrequetly under small shocks; Therefore, if price level doesn t change proportionally with money supply, there will be change in real demand; As a result, central bank can use monetary policy to shift short-term real demand and stabilize the output; How does central bank respond to supply / demand shocks and conduct properly designed optimal monetary policy rules? Traditional IS-LM view and modern rocket science.
Recap: monetary economics in IS LM world LM curve: combinations of nominal interest rate and output that lead to money market equilibrium for given price level; Based on liquidity preference theory, M money base, P price level, i nominal interest rate, Y output ( ) M P = L ( ) i, (+) Y. 0 = L i i Y + L Y i Y = L Y L i > 0.
Recap: monetary economics in IS LM world IS curve: goods market equilibrium such that planned and actual expenditure on output are equal; Based on Keynesian cross, Y real income, i π e real interest rate, G government expenditure, T taxes ( ) (+) ( ) Y = E Y, i π e, (+) G, ( ) T, 0 < E Y < 1. Y i = E Y Y i + E (i π e ) Y i = E (i π e ) 1 E Y < 0.
Monetary expansion in IS LM world i LM LM IS Y
Target for monetary policy: money supply Targeting money supply leads to maximum volatility in real output: i i LM IS IS IS Y Y Y Y institution-logo-filen
Target for monetary policy: real output Targeting real output leads to maximum volatility in nominal interest rate (inflation): i LM i i i IS IS IS Y Y institution-logo-filen
Variation in inflation Choosing targets for monetary policy: loss function People dislike both inflation and output fluctuations central bank s aim: min L = (Y Y ) 2 + α (π π ) 2 ; Short-term trade-off: flexible inflation targeting. Short-term trade-off in monetary policy Strict output target Flexible inflation target Variation in output Strict inflation target institution-logo-filen 6 6
The rocket science of modern monetary policy However, in the past two decades central bank went far beyond IS LM world: Micro-founded framework to better understand relevant frictions and impacts on conducting monetary policy; A framework of fluctuations to capture the stylized facts of the uncertain world; Estimated models for better quantitative analysis and forecasting; General equilibrium to see co-movements; Dynamic model for intertemporal trade-offs; Work horse in modern central banks: Dynamic Stochastic General Equilibrium (DSGE) model.
Ingredients in a standard DSGE model Infinite time horizon. In each period: Households: making decisions on labor supply, consumption / saving, investments in financial assets; Firms: monopolistic competition, employing labor and capital; Central bank: conducting monetary policy rule to stabilize price and output; Price stickiness: only some firms can adjust prices in each period. Shocks: technological shock to firms productivity.
The canonical new Keynesian system New Keynesian IS curve: θ coefficient of relative risk aversion, ŷ output gap (deviation from natural rate) ŷ t = E t [ŷ t+1 ] 1 θ {i t E t [π t+1 ]} ; New Keynesian Phillips curve: u a t productivity shock π t = κŷ t + βe t [π t+1 ] + u a t ; Monetary policy rule (Taylor Principle): r n natural real interest rate i t = r n + φ π E t [π t+1 ] + φ y E t [ŷ t+1 ], φ π > 1.
What s new in new Keynesian? Woodford revolution: short-term interest rate (i t ), instead of money base, is the sufficient tool to stabilize price and output; Forward-looking: Today s aggregate demand and inflation respond to people s expectation on future output and inflation; Therefore, central bank should follow a forward-looking monetary policy rule, plus actively and credibly managing people s inflation expecation.
New Keynesian monetary policy targets Objective: loss function minimization { + min L t = E t β τ [ ŷt+τ 2 + αˆπ t+τ 2 ] } ; τ=0 With new Keynesian IS curve: ŷ t = E t [ŷ t+1 ] 1 θ {i t E t [π t+1 ]} ; And new Keynesian Phillips curve: π t = κŷ t + βe t [π t+1 ] + u a t.
Optimal monetary policy rules Central bank needs optimal monetary rules to achieve the optimal outcome, which is not trivial; The biggest barrier is time-inconsistency problem Political pressure to push output beyond natural rate expansionary monetary policy by surprise inflation by surprise; If central bank does so, people would raise inflation expecation in the first place; This makes monetary policy ineffective. Need to build up credibility: being independent, delegation by conservative central bankers, etc.
Monetary policy and financial stability On the micro level of transmission mechanisms Monetary policy in practice works directly on banks balance sheets; Therefore, it has a great potential to affect banks risk-taking behavior risk-taking channel ; However, central bank s monetary policy decision is based on macro DSGE framework Where financial frictions are poorly modeled, if not non-existing at all; Banking sector there is rather passive financial accelerator, not trouble maker; Is such biased policy to be blamed for current crisis? institution-logo-filen