GLA 1001 MACROECONOMICS M , I G - University of Toronto 07...Inflation,” FRBSF Economic Letter 2012-21, 9 July 2012. The failure of money supply targeting explains the emergence

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


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)


∆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


MONEY SUPPLY AND INFLATION


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


FEDERAL RESERVE TOTAL ASSETSJANUARY 2006 TO JANUARY 2019


Source: Board of Governors of the Federal Reserve System (US).

U.S.: MONEY SUPPLY AND INFLATION


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


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)


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


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



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


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


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


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


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


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?


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?

Documents

GLA 1001 MACROECONOMICS M , I G - University of Toronto 07...Inflation,” FRBSF Economic Letter 2012-21, 9 July 2012. The failure of money supply targeting explains the emergence