View
3
Download
0
Category
Preview:
Citation preview
GLA 1001MACROECONOMICS:
MARKETS, INSTITUTIONS AND GROWTH
LECTURE 7:THE IMPLEMENTATION OF MONETARYPOLICY
© Gustavo Indart Slide 1
Money is added as an after thought to a model based on a barter paradigm Money is neutral in the long run (it only determines
nominal prices)
This view is based on the Quantity Theory of Money
where 𝑷𝑷 is the price level, 𝒚𝒚 is real income (output), 𝑽𝑽 is the velocity of money, and 𝑴𝑴 is the quantity of money
If 𝑽𝑽 and 𝒚𝒚 are assumed constant, then an increase in 𝑴𝑴 must translate necessarily into an increase in 𝑷𝑷
MONEY IN NEOCLASSICAL THEORY
© Gustavo Indart Slide 2
𝑷𝑷𝒚𝒚 = 𝑽𝑽𝑴𝑴 𝑷𝑷 =𝑽𝑽𝒚𝒚𝑴𝑴
Assumption: The central bank controls the money supply (𝑴𝑴) through its control of the monetary base (𝑩𝑩), where
and 𝒎𝒎𝒎𝒎 is the money multiplier
Neoclassical theory thus assumes that: The central bank has full control over 𝑩𝑩 And 𝒎𝒎𝒎𝒎 is constant
Therefore, when the central bank changes 𝑩𝑩:
MONEY IN NEOCLASSICAL THEORY (CONT’D)
© Gustavo Indart Slide 3
∆𝑴𝑴 = 𝒎𝒎𝒎𝒎∆𝑩𝑩
𝑴𝑴 = 𝒎𝒎𝒎𝒎𝑩𝑩
Central banks used money supply targets to curb inflation in the 1970s and 1980s It was thought that the money supply was an exogenous
variable fully determined by the central bank
Two conditions must be satisfied for money supply targetingto be successful: Central bank must be able to control the money supply Relationship between inflation and money supply must
be reliable
But, as the following chart suggests, the relationship between money supply and inflation might not be so reliable
THE USE OF MONEY SUPPLY TARGETS
© Gustavo Indart Slide 4
MONEY SUPPLY AND INFLATION
© Gustavo Indart Slide 5
Central banks realized in the 1980s that they had no directcontrol over the money supply
Central banks could at most control the monetary base But relationship between monetary base and inflation is
weak
As a matter of fact, the relationship between the monetary base and the money supply is also weak And this is so because the money multiplier is not fixed
Further, central banks might not even be able to fully control the monetary base The latter might be an endogenous variable
THE FAILURE OF MONEY SUPPLY TARGETS
© Gustavo Indart Slide 6
FEDERAL RESERVE TOTAL ASSETSJANUARY 2006 TO JANUARY 2019
© Gustavo Indart Slide 7
Source: Board of Governors of the Federal Reserve System (US).
U.S.: MONEY SUPPLY AND INFLATION
© Gustavo Indart Slide 8
Money Multipliers
Inflation Monetary Base
Period 2008-2012• Average rate of inflation below 2%• Monetary base tripled• Money multipliers plummeted
Source: John C. Williams, “Monetary Policy, Money, and Inflation,” FRBSF Economic Letter 2012-21, 9 July 2012.
The failure of money supply targeting explains the emergence of the modern monetary policy framework The 3-equation model is based on this framework Now inflation target becomes the nominal anchor The central bank uses monetary policy rule as modelled
by the MR curve
Instead of using an intermediate target of the money supply, the central bank now: Announces the inflation target to anchor inflation
expectations Chooses the desired degree of tightening by setting the
interest rate directly
THE MODERN MONETARY POLICYFRAMEWORK
© Gustavo Indart Slide 9
As we have seen, the central bank minimizes its loss function:
subject to (the Phillips curve constraint):
This way it determines the monetary rule, i.e., the equation for the MR curve:
THE MODERN MONETARY POLICYFRAMEWORK (CONT’D)
© Gustavo Indart Slide 10
𝑳𝑳 = (𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆)𝟐𝟐 + 𝜷𝜷(𝝅𝝅𝒕𝒕 − 𝝅𝝅𝑻𝑻)𝟐𝟐
𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕−𝟏𝟏 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆
𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆 + 𝜶𝜶𝜷𝜷(𝝅𝝅𝒕𝒕 − 𝝅𝝅𝑻𝑻) = 𝟎𝟎
𝝅𝝅𝒕𝒕 = 𝝅𝝅𝑻𝑻 −𝟏𝟏𝜶𝜶𝜷𝜷
𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆
MODELLING MONETARYPOLICY The central bank’s best response to an inflation or output
shock is its monetary policy rule expressed by the MR curve Central bank preferences (trade-off between inflation
and unemployment, 𝜷𝜷) affect slope of MR curve Slope of the Phillips curve (𝜶𝜶) also affects the slope of
the MR curve
The nominal rate of interest is changed frequently to achieve the inflation target at least cost The central bank follows a ‘rule-based’ approach and
it’s very active
© Gustavo Indart Slide 11
𝝅𝝅𝒕𝒕 = 𝝅𝝅𝑻𝑻 −𝟏𝟏𝜶𝜶𝜷𝜷
𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆
Inflation is reduced through an increase in unemployment The sacrifice ratio is the unemployment cost of reducing
inflation The sacrifice ratio represents the percentage-point
increase in unemployment given a one percentage-point reduction in inflation
The “cold-turkey” or “shock therapy” approach refers to central bank preference for a significant decrease in output to bring inflation down faster
The “gradualist” approach refers to central bank preference for a lower increase in unemployment and a longer disinflation process
DISINFLATION STRATEGIES
© Gustavo Indart Slide 12
© Gustavo Indart Slide 13
THE BEST RESPONSE TAYLOR RULE
The best response interest rate rule is known as the Taylor rule It is derived from the optimizing behaviour of the
central bank
For 𝒕𝒕 = 𝟏𝟏, the three equations of the model are:
(PC curve)
(IS curve)
(MR curve)
𝝅𝝅𝟏𝟏 = 𝝅𝝅𝟎𝟎 + 𝜶𝜶(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆)
𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆 = −𝒂𝒂(𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔)
𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆 = −𝜶𝜶𝜷𝜷(𝝅𝝅𝟏𝟏 − 𝝅𝝅𝑻𝑻)
1
2
3
© Gustavo Indart Slide 14
THE BEST RESPONSETAYLOR RULE (CONT’D) Substituting into we get:
𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆 = −𝜶𝜶𝜷𝜷[𝝅𝝅𝟎𝟎 + 𝜶𝜶(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆) − 𝝅𝝅𝑻𝑻]
Dividing both sides of the equation by −𝜶𝜶𝜷𝜷 we get:
−(𝟏𝟏𝜶𝜶𝜷𝜷
)(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆) = 𝝅𝝅𝟎𝟎 + 𝜶𝜶(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆) − 𝝅𝝅𝑻𝑻
−(𝟏𝟏𝜶𝜶𝜷𝜷
+ 𝜶𝜶)(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆) = 𝝅𝝅𝟎𝟎 − 𝝅𝝅𝑻𝑻
And substituting into we get:
𝒂𝒂(𝟏𝟏𝜶𝜶𝜷𝜷
+ 𝜶𝜶)(𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔) = 𝝅𝝅𝟎𝟎 − 𝝅𝝅𝑻𝑻
𝝅𝝅𝟏𝟏 = 𝝅𝝅𝟎𝟎 + 𝜶𝜶(𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆)𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆 = −𝒂𝒂(𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔)𝒚𝒚𝟏𝟏 − 𝒚𝒚𝒆𝒆 = −𝜶𝜶𝜷𝜷(𝝅𝝅𝟏𝟏 − 𝝅𝝅𝑻𝑻)
1
2
3
1 3
4
2 4
5
© Gustavo Indart Slide 15
THE BEST RESPONSETAYLOR RULE (CONT’D) And dividing both sides of the equation by 𝒂𝒂( 𝟏𝟏
𝜶𝜶𝜷𝜷+ 𝜶𝜶) we get:
And assuming, for simplicity, 𝒂𝒂 = 𝜶𝜶 = 𝜷𝜷 = 𝟏𝟏, then
Equation suggests that a 1 percentage point increase in 𝝅𝝅 over 𝝅𝝅𝑻𝑻 calls for a 0.5 percentage point increase in 𝒓𝒓 as the central bank best response
𝒂𝒂(𝟏𝟏𝜶𝜶𝜷𝜷
+ 𝜶𝜶)(𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔) = 𝝅𝝅𝟎𝟎 − 𝝅𝝅𝑻𝑻5
6𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔 =𝟏𝟏
𝒂𝒂 𝟏𝟏𝜶𝜶𝜷𝜷 + 𝜶𝜶(𝝅𝝅𝟎𝟎− 𝝅𝝅𝑻𝑻)
𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔 = 𝟎𝟎.𝟓𝟓 (𝝅𝝅𝟎𝟎− 𝝅𝝅𝑻𝑻) 7
7
© Gustavo Indart Slide 16
THE BEST RESPONSE TAYLOR RULE (CONT’D)
Let’s go back to the general Taylor rule equation:
The Taylor rule equation suggests the following central bank best responses: As 𝜷𝜷 increases (MR curve becomes flatter), desired
output gap rises and a larger increase in 𝒓𝒓 is required As 𝜶𝜶 increases (PC curve becomes steeper), desired
output gap falls and a smaller increase in 𝒓𝒓 is required As 𝒂𝒂 increases (IS curve becomes flatter), any desired
output gap requires a smaller increase in 𝒓𝒓
6𝒓𝒓𝟎𝟎 − 𝒓𝒓𝒔𝒔 =𝟏𝟏
𝒂𝒂 𝟏𝟏𝜶𝜶𝜷𝜷 + 𝜶𝜶(𝝅𝝅𝟎𝟎− 𝝅𝝅𝑻𝑻)
As we have seen, the Taylor rule calls for negative nominal interest rates in some instances But the zero lower bound implies that desired output
gap cannot always be achieved Therefore, conventional monetary policy do not work in
these cases Central banks must then adopt other instruments
(unconventional monetary policy) to stimulate aggregate demand
The main unconventional monetary policy used by developed countries’ central banks is quantitative easing Central banks create money to buy financial assets
UNCONVENTIONAL MONETARY POLICY INTHE GREAT RECESSION
© Gustavo Indart Slide 17
Conventional monetary policy has a clear transmission mechanism: Changes in the interest rate affect AD and thus output
and inflation
Quantitative easing might affect AD through two main transmission channels: Higher asset prices might cause consumption to
increase through the wealth effect Investors who sold government bonds might use this
money to invest abroad, thus depreciating the currencyand increasing net exports
THE TRANSMISSION MECHANISM OFQUANTITATIVE EASING
© Gustavo Indart Slide 18
The Fed asset portfolio increased from $850bn (6.3% of GDP) in 2006 to $2.8tr (19% of GDP) in 2006 and to $4.5tr (28% of GDP) in 2015
There are a number of possible risks attributed to quantitative easing: Central bank independence is compromised, thus
decreasing its credibility It might contribute to increasing inflation expectations It might risk creating new asset bubbles It creates excess reserves and thus a greater risk of
increasing the money supply too much
QUANTITATIVE EASING: IS ITDANGEROUS?
© Gustavo Indart Slide 19
GLA 1001�Macroeconomics: �Markets, Institutions and GrowthMoney in Neoclassical TheoryMoney in Neoclassical Theory (cont’d) The Use of Money Supply TargetsMoney Supply and InflationThe Failure of Money Supply TargetsFederal Reserve Total Assets�January 2006 to January 2019U.S.: Money Supply and InflationThe Modern Monetary Policy FrameworkThe Modern Monetary Policy Framework (cont’d)Modelling Monetary �PolicyDisinflation StrategiesThe Best Response Taylor RuleThe Best Response �Taylor Rule (cont’d)The Best Response �Taylor Rule (cont’d)The Best Response Taylor Rule (cont’d)Unconventional Monetary Policy in the Great RecessionThe Transmission Mechanism of Quantitative Easing Quantitative Easing: Is It Dangerous?
Recommended