Monetary and Fiscal Policy

Monetary and Fiscal Policy Part 3: Monetary in the short run Lecture 6: Monetary Policy Frameworks, Application: Inflation Targeting Prof. Dr. Maik Wolters Friedrich Schiller University Jena

Outline Part 1: Introduction Part 2: Monetary and Fiscal policy in the Long Run Part 3: Monetary Policy in the Short Run Lecture 6: Monetary Policy Frameworks, Inflation Targeting Lecture 7: Price and Wage Rigidities Lecture 8: The New Keynesian Baseline Model Lecture 9: Empirical Monetary Policy Transmission and Large DSGE models Lecture 10: Optimal Monetary Policy Part 4: Fiscal Policy in the Short Run 2

Learning Objective of Todays Lecture 1. How do central bank s conduct monetary policy? What is their general framework? 2. What is inflation targeting? Why do inflation forecasts play a crucial role? 3. What are monetary policy rules? Understand that they describe optimal monetary policy in many models and that they also empirically describe interest rate setting of central banks well. 3

Literature Required reading: Svensson, Lars E.O. (1997). Inflation forecast targeting: implementing and monitoring inflation targets, European Economic Review, 41(6): 1111-1146. Optional reading Taylor, John B. (1993). Discretion versus policy rules in practice, Carnegie- Rochester Conference Series on Public Policy, 39: 195-214. Walsh, pp 511-529: optimal instrument choice based on Poole s (1970) model 4

Framework of Monetary Policy How the central bank thinks about the way in which it goes about setting monetary policy What is it trying to do? How is it trying to do that Also called the monetary policy strategy Increased transparency and clarity have improved monetary policy in recent decades. Four components: 1. Ultimate objective(s) 2. Intermediate target(s) 3. Information or indicator variables 4. Policy instruments 5

1. Ultimative Objective(s) The overriding objective for monetary policy is to contribute to increased public welfare Two problems: Welfare is difficult to measure How to make this objective operational Governments or parliaments define the ultimate objectives for monetary policy The exact interpretation of this ultimate objective is sometimes done by the central bank itself: ECB defines its understanding of price stability Typically stated in the law governing the central bank. 6

Arriving at an ultimate objective Two propositions from theory: Monetary policy impacts in the long run after all adjustments in the economy have worked through only on nominal variables: increase in money leads to an increase in inflation Any impact on real variables such as employment or growth is temporary: long run neutrality of money Classical dichotomy Central banks ultimate objective is typically low and stable inflation But frequently secondary objective of dampening business cycles Somestimes no clear hirarchy of goals: Fed s dual mandate Current discussions are about adding a new objective - financial stability. This possibly creates new trade-offs: Business cycle vs. financial cycle stabilization Financial stability vs. consumer price stability 7

Federal Reserve s objective Statutory objectives established by the Congress: maximum employment, stable prices, and moderate long-term interest rates FOMC defined goals (January 2012): Inflation: 2% PCE inflation rate is most consistent over the longer run with the Federal Reserve's statutory mandate Employment Monetary policy can influence the level of employment over the medium run The maximum level of employment that the economy can sustain in the longer run, without inflation accelerating, is determined by nonmonetary factors that affect the structure and dynamics of the job market, such as population trends and technological innovation. These factors may change over time and may not be directly measurable. As a result, the FOMC does not specify a fixed goal for maximum employment Hirarchy: Under circumstances in which the Committee judges that the two objectives are not complementary, it follows a balanced approach in promoting them Source: http://www.federalreserve.gov/faqs/money_12848.htm 8

ECB s objective Treaty establishing the European Community, Article 105 (1): To maintain price stability is the primary objective of the Eurosystem Without prejudice to the objective of price stability, the Eurosystem will also support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community. These include a high level of employment and sustainable and non-inflationary growth. The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Governing Council has clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term Source: http://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html 9

ECB s Objective 4 3,5 3 2,5 2 1,5 1 0,5 0-0,5-1 Inflation Euro Area (Changing Composition) Mean 10

2. Intermediate objectives Used by few central banks explicitly, but historically and conceptually important Motivation Difficult to know whether monetary policy is too/insufficiently expansionary because it impacts on the economy with a lag: Inflation: 2-3 years Economic activity: 1 year MP Shock Prices MP Shock Output Source: Christiano, L. J., M. Eichenbaum, and C. L. Evans (1999). Monetary policy shocks: What have we learned and to what end? Handbook of Macroeconomics. 11

Intermediate Target Policy may impact more rapidly on another variable that in itself is unimportant Can be used as a measure of the stance of policy: Money growth Exchange rate Inflation forecast Core inflation Establish intermediate target for this variable and change policy whenever it deviates from target If there is a conflict between intermediate and final target, then focus on the latter 12

Monetary Targeting Used by Bundesbank, 1975-1998; currently used by some emerging market central banks In bank-centered financial systems, banks lending and deposit taking may be closely related to macroeconomic developments. Money growth historically closely correlated with inflation. Set target for money growth and raise (reduce) interest rates if it is high (low) unless there is other information to the contrary. 13

Exchange Rate Targeting Currently used by Denmark and others Typically a fixed target or a target zone for the exchange rate By fixing the exchange rate to a low inflation economy, the central bank hopes to achieve about the same inflation rate as the foreign economy Set target for exchange rate and raise (cut) interest rates if the domestic currency depreciates (appreciates) 14

Inflation (Forecast) Targeting Intermediate targets were adopted because of a combination of policy lags and difficulties of forecasting future economic conditions Better economic models, econometric techniques and IT systems have improved forecasting Most central banks now use an inflation forecast as intermediate objective: No need to focus on a single variable such as money growth or the exchange rate Example: Bank of England Inflation Report May 2016 15

3. Information/Indicator variables Variables that the central bank finds particularly useful for forecasting the future state of the economy Similar to intermediate objectives, but no attempt to control them Prominent example: ECB and M3 growth Many others: e.g. output gap, import prices, exchange rates, money and credit growth, slope of term structure of interest rates, long interest rates Much less important if a forecasting model is used 16

ECB s Economic Analysis Pillar 1: Assess the short to medium-term determinants of price developments. The focus is on real activity and financial conditions in the economy. The economic analysis takes account of the fact that price developments over those horizons are influenced largely by the interplay of supply and demand in the goods, services and factor markets. To do so, the ECB regularly reviews, inter alia, developments in overall output, demand and labour market conditions, a broad range of price and cost indicators, fiscal policy, and the balance of payments for the euro area. 17

ECB s Monetary Analysis Pillar 2: Focus on a longer-term horizon than the economic analysis. It exploits the long-run link between money and prices. The monetary analysis mainly serves as a means of crosschecking, from a medium to long-term perspective, the short to medium-term indications for monetary policy coming from the economic analysis 18

4. Policy instruments The tools central banks use to steer the economy In models so far, the choice variables, or instruments, of the central bank has been the nominal money supply. This is appropriate to think about long-run developments of prices (Quantity Theory) We have not distinguished between narrow (M0, M1) and broad monetary aggregates (M2, M3) (and we have ignored differences between short- and long-term interest rates) In reality, the central bank can only exercise close control over the money base and the (very) short-term nominal interest rate In the real world, most central banks use the nominal interest rate as a policy instrument and adjust the monetary base to attain some target value of the nominal interest rate. One can show (see Walsh, pp 511-529, based on the model by Poole, 1970) that the optimal instrument choice depends on the variability of shocks Relatively high money demand volatility, relatively low aggregate demand volatility use the nominal interest rate as instrument; otherwise money supply Can explain why real-life central banks are using interest-rate operating procedures as money demand is unstable and/or financial markets are volatile Hence, we will focus on the nominal interest rate in the following, but keep in mind that there are alternatives (at the zero lower bound, central banks must switch to other instruments) 19

Application: Inflation Targeting Strict inflation targeting Announce target for inflation and use policy instruments to achieve this target Raise/cut interest rates if (forecasted) inflation is above/below target Highly transparent, but restrictive Flexible inflation targeting Give some weight to output stabilization in addition to an inflation target Formal or informal versions of flexible inflation targeting have been adopted by most central banks A growing number of countries adopted inflation targeting in the 1990s Examples: New Zealand 1990, Canada 1991, UK 1992, Sweden 19993, Peru 1994, South Africa 2000, Norway 2001, Hungary 2001, 20

Svensson s Model Use model by Svensson: European Economic Review (1997) Think of t and t+1 to be one year apart ( annual data ) Disregard expectations backward looking model; inflation depends on past inflation Solving the model to show how interest rate setting depends inflation and output Disregard uncertainty for the moment In reality: Current inflation is unknown The current output gap is unknown The neutral interest rate is unknown The parameters of the model are unknown The model itself may be unknown 21

Model Equations Backward looking Phillips curve: Aggregate demand (IS) curve: π t+1 = π t + α 1 y t + ε t+1 y t+1 = β 1 y t β 2 (i t π t ) + η t+1 Transmission meachism: i t y t+1 π t+2 Consistent with VAR evidence, and presenting the cnetral bank with a challenge: ε t+1, η t+1, η t+2 are unknown in period t Variables are to interpreted as percentage deviations from steady state, i.e. in the long run y t = π t = i t = 0 when they return to steady state values. 22

Strict Inflation Targeting Intertemporal loss function: E t τ=t δ τ t L π t π Note: The output gap is assumed not to enter the loss function strict inflation targeting Central bank s problem: Find i t, i t+1, i t+2,, i to minimize loss 23

Simplify the Optimization Problem Per-period loss function: L π t = 1 2 π t π 2 Since i t affects π t+2 but not π t and π t+1, solve for π t+2 : Recall π t+1 = π t + αy t + ε t+1 24

Derive Intermediate Target Define: a 1 = 1 + α 1 β 2 ; a 2 = α 1 1 + β 1 y t ; a 4 = α 1 β 2 We then have that: π t+2 = a 1 π t + a 2 y t a 4 i t + (ε t+1 + α 1 η t+1 + ε t+2 ) So the CB s target variable, π t+2, depends on current values of π, y, and i. Set i = f(π, y) in such a way as to E t π t+2 = π 25

Simplify dynamic problem to period-by-period problem i t does not affect π t, π t+1, but π t+2, π t+3 i t+1 does not affect π t+1, π t+2, but π t+3, π t+4 The solution can be found by assigning i t so that E t π t+2 = π, set i t+1 so that E t π t+3 = π and so on. Solve simple period-by-period problem: 2 min Et L( t 2) i t 26

First Order Condition First-order condition: Optimal to set interest rates such that: 27

Policy rule Recall: Inflation forecast must be equal to inflation target: Solving: Taylor type rule: 28

Notes to the solution Note that although the output gap doesn t enter in the loss function, the central bank reacts to it. The reason is that the output gap is a good indicator of future inflation: π t+2 and E t (π t+2 ) depend on y t (and on π t ) Notice that Inflation deviates randomly from target because of shocks that occur after the interest rate is set 29

Sample Path for Inflation Under Strict Inflation Targeting 30

Flexible Inflation Targeting So far we have assumed that the central bank does not care about economic activity: Only inflation enters the loss function But plenty of evidence that central banks are also concerned about economic activity. Change loss function: L π t = 1 2 π t π 2 λy t 2 λ > 0 captures relative weight on output stabilization λ = 0: strict inflation targeting Solution is much more complicated and results in the following Taylor rule Much smaller interest rate movements compared to strict inflation targeting since the central bank does not want the output gap move too much; it takes longer for inflation to go back to steady state, but the volatility of the output gap is smaller. 31

Targeting Rule vs Instrument Rule FOCs are targeting rules General condition that the central bank should fulfill Can be implemented using different models and one can use more information to forecast inflation than contained in one specific model No explicit recipe how to adjust the interest rate Possibility in making mistakes in interest rate setting as no precise formula is given Commitment to target rule in reality not totally implausible Instrument rules Precise formula how to set the interest rate given a specific model Less flexible and possibly less robust than targeting rule Interest rate setting might be inefficient if the model is misspecified No central bank would commit to a narrowly defined instrument rule 32

Monetary Policy Rules: The Taylor Rule Taylor rule: i t = r + π t + α π t π Neutral level: i = r + π + βy t Taylor (1993) found that α = β = 0.5 and r = π = 2% described US monetary policy in the late 1980s and early 1990s well i t = 2 + π t + 0.5 π t 2 + 0.5y t If we oberseve an increase of inflation by 1% then increase the nominal interest rate by more than 1%: 1 + α Called the Taylor principle. Ensures that monetary policy is inflation stabilizing. Leads to determinacy in a wide range of macroeconomic models Intuition: raise nominal interest rate more than the increase in inflation increase in the real interest rate decrease in economic activity with a lag (sticky prices) decrease of inflation 33

Original Taylor rule Source: Taylor (1993). Discretion versus policy rules in practice, Carnegie-Rochester Conference Series on Public Policy 39: 195-214. 34

Backside of John Taylor s business card 35

Taylor Rule and ECB policy Sauer, S. and J.-E. Sturm (2003), Using Taylor rules to understand ECB monetary policy, Munich: CESifo Working Paper, 1110, December. 36

Fed Fund s rate pre housing crisis 37

Interest Rate Smoothing Simple Taylor Rule has difficulties to capture gradual adjustment of interest rates Most interest rate changes represent continuations in the direction of policy 38

Policy rules with interest rate smoothing Ultimate target rate: i t = r + π t + α π t π + βy t Gradual adjustment: i t = ρi t 1 + 1 ρ i t Combine the two equations: i t = ρi t 1 + 1 ρ [r + π t + α π t π + βy t ] Interest rate smoothing may be optimal even if the objective of the central bank is to stabilize inflation and output, but not the interest rate volatility Three explanations of interest-rate smoothing: Forward-looking behavior of market participants Measurement error associated with key macroeconomic variables Uncertainty regarding relevant structural parameters More on monetary policy rules (estimation, revised vs real-time data, ) in the course Empirical Macroeconomics 39

Summary The framework of central bank includes (up to) four components: 1. Ultimate objective(s), 2. Intermediate target(s), 3. Information or indicator variables, 4. Policy instruments The Taylor rule arises as the optimal solution to the central bank s policy problem Under strict inflation targeting, the central bank reacts to current inflation and output because both impact on future inflation Under flexible inflation targeting, the central bank smoothes output at the cost of worse inflation control The parameters in the Taylor rule depend on The structure of the economy The weight attached to output in the central bank s loss function Empirical monetary policy rules describe actual interest rate setting of central banks well and are important benchmarks (in particular the Taylor rule) 40