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Monetary Policy and the Role of Central Banks

MSc/Diploma in Economics, Banking and Finance (Core Module)

MSc/Diploma in International Banking and Finance (Core Module)

Course Coordinator: Professor Campbell Leith

Lecturers: Prof C. Leith and Prof T. Kirsanova




• Contact by email. [email protected]@glasgow.ac.uk

• Lectures Mon 9-11, repeated Tues 10-12. One lecture a week.

2

This lecture lasts for two hours, for ten weeks.

• There are no tutorials in this class.




• Assessment

(1) Exam in May/June 2011. (75% of total marks )

Students should answer 2 out of 4 questions.

2 hour exam.

3

.

Essay Topic in Handbook.

• Text Book

No recommended text book.

Extensive reading list provided in Course Module.



Some Definitions

• Monetary Policy

– A central bank's actions which affect the quantityand/or cost of money and credit.

4

• Central Banks

– typically the institutions that control monetary policy in

a country

• e.g. Federal Reserve in the US and the EuropeanCentral Bank in the Euro Area



Increasing Number of Central Banks

5

Source: King, M. (1999), “Challenges for Monetary Policy: New and Old”, paper

presented at symposium, Jackson Hole Wyoming.



Monetary Policy and the Role of Central Banks:

Course Objectives

• What aims does Monetary Policy have and why?

• What means are at a Central Banks’ disposal to achieve

these aims?

6

• How Monetary Policy affects the economy?

• What was wrong with post WWII monetary policy andwhat are the solutions?



Global Inflation

7

Source: King, M. (1999), “Challenges for Monetary Policy: New and Old”,paper presented at symposium, Jackson Hole Wyoming.



Inflation – The Great Moderation

Inflation - The Great Moderation

20

25

30

8

-5

0

5

10

15

1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009

Year

% a g e United Kingdom

United States

Source: OECD



Inflation More Recently

Inflation

6

7

8

9

10

United Kingdom

9Source: OECD

-1

0

1

2

3

4

5

1993 1995 1997 1999 2001 2003 2005 2007 2009

Year

% a

g e United States

G7

OECD - Europe



Inflation More Recently

Inflation - BRICs

15

20

25

10Source: OECD

-5

0

5

10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Year

% a g e

ChinaIndia

Russian Federation



The Goals of Monetary Policy

• Controlling Inflation……

• Unemployment and output (i.e. real variables)

11

– real factors and long-run.

– nominal variables

• Monetary policy and fiscal policy.



Instruments of Monetary Policy

(A) Direct Controls

- setting quantity and price of money or credit

12

(B) Indirect Controls- using the market mechanism

- What happened in the credit crunch and how does

that affect monetary policy?



The Monetary Policy Transmission Mechanism

• Examine the connection between instruments and goals

– How changes in policy affect the economy.

– The monetary transmission mechanism.

• Official interest rates affect spectrum of bank rates.

13

• Credit Channel, quantity versus price of money.

• Policy lags

• Different experience across countries.



How Central Banks Behave in Practice

• Look at the data for how central banks behave

• Taylor identified a simple equation that could summarize much ofthe complexity in monetary policy

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• The role of inflation and other variables in determining monetarypolicy

• In particular role for

– expected inflation – smaller role for spare capacity in the economy

– role for interest rate smoothing



Other Issues in Monetary Policy Design

• An Inflation bias can arise when monetary policy is in the hands ofpoliticians

– Govt declares low inflation goal but springs a monetary surpriseto boost real economy

– If public expects this, this can fuel inflation

15

• Suggestion is that we should take monetary policy out of the handsof politicians

– Have credible monetary policy from independent central banksor inflation targets



Lectures 2-5: The Goals of Monetary Policy

• Stated Objectives of Central Banks

• The Trade-Off Between Output and Inflation

16

• The Fiscal Role of Central Banks



The Goals of Central Banks

• Why Inflation is important? Experience

• Inflation varies greatly across countries and across time.

– GE, JP, UK, IT, US

• Extreme examples

17

– Deflation – Hyperinflation

• Data suggests that inflation has been higher than is socially optimal

• Q: “Do you agree that preventing high inflation is an importantnational priority, as important as preventing drug abuse orpreventing deterioration in quality of our schools?”



Attitudes towards Inflation

• How Important is Preventing Inflation?

1 2 3 4 5

Fully

Agree

Undecided FullyDisagree

18

• Miles and Scott (2005) Macroeconomics: Understanding the Wealth ofNations.

Citizens 52 32 4 8 4

Economists 18 28 11 26 18



Theoretical Costs of Inflation

• Costs of Unanticipated Inflation

(a) Microeconomic Costs

19

(b) Distribution Costs

(c) Resource Costs



Inflation and Inflation Volatility

20



Theoretical Costs of Inflation

• Costs of Anticipated Inflation

(a) Shoe Leather

21

(b) Menu Costs

(c) Distortions in the Tax system



Stated Objectives of Central Banks

• Typical Objectives

• Ensuring a low and stable rate of inflation.

• Supporting full employment/economic development.

22

• Ensuring financial stability.

• Generating fiscal revenues (largely developing countries).



The United States Fed’s Legislative Mandate

Fed Reserve Act 1913 - “provide an elastic currency ” i.e. act as a

‘lender of last resort’. No mention of other macroeconomic goals.

1977 Amendment to the Act - “shall maintain long-run growth of

the monetary and credit aggregates commensurate with the

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economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable

prices and moderate long-term interest rates ”.

Low and Stable Rate of Inflation

Maximum Employment



The European Central Bank’s Legislative Mandate

ECB’s Charter “The primary objective of the European System of

Central Banks is to maintain price stability. Without prejudice to

the objective of price stability, the ESCB shall support the general

economic policies in the Community ”. The Community’s policies

include “a high level of employment ” and “a balanced development

24

of economic activities ”.

Low and stable rate of inflation.

Less emphasis on full/maximum employment.



The Bank of England’s Legislative Mandate

Bank of England Act 1998,

“the objectives of the Bank of England shall be-

(a) to maintain price stability, and

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(b) subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment .”



The Bank of Japan’s Legislative Mandate

Bank of Japan Act Article 1

“The objective of the Bank of Japan, as the central bank of

Japan, is to issue banknotes and to carry out currency and

monetary control. In addition... the Bank's objective is to

ensure smooth settlement of funds among banks and other

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financial institutions, thereby contributing to the maintenance of an orderly financial system .”

Bank of Japan Act Article 2

“Currency and monetary control shall be aimed at, through the

pursuit of price stability, contributing to the sound

development of the national economy .”



Output-Inflation Trade Off

• The Phillips Curve

– This identifies a relationship between output and inflation.

• However it was believed that the relationship had broken down inthe 1970s.

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• Friedman developed theory which suggested that there was no long-run relationship between output and inflation.

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Lect 1 2 Cbl Compatibility Mode