Macroeconomic Diagnostics ( MDSx) Module 5...Required Negative Space (Not for instructor notes.) Please do not adjust text field positions. Ultimate Objective of Monetary Policy Low

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Module

Analyzing Monetary Policy

Macroeconomic Diagnostics (MDSx)5

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About Module 5

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Macroeconomic Diagnostics (MDSx)

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Introducing Monetary Policy Objectives

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Ultimate Objective of Monetary Policy

Low and stable inflation

A characteristic of general macroeconomic stability.

Helps more efficient resource allocation.




Primacy of the Inflation Objective

Unemployment / output

Exchange rate

Good practice is…

Policy mandates might assume other objectives:

Primacy of the Inflation Objective




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Operating and Intermediate Targets

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Diagnosing the Problem

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To achieve the objective the central bank…

Adjusts policy instruments to affect: Cost of domestic reserve money

Supply of domestic reserves

Alters aggregate real monetary conditions: Real market interest rates

Real exchange rate

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Key Diagnostic Questions

How are the policy operating/intermediate variables aligned with a target?

What are the resulting real monetary conditions?




Diagnostic Characterizations

Neutral

Expansionary

Contractionary

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Policy stance - Neutral

Operating and intermediate variables –

Are at ‘targets’ consistent with…

… output at the potential; and

… inflation and inflation expectations at the objective.

Real Monetary Conditions and Demand and Inflation

Constrained Neutral Stimulated

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Policy stance - Expansionary


Are not aligned with the ‘neutral’ level.

Real Monetary Conditions –

Undervalued domestic currency

Cheap credit

Demand and Inflation –





Policy stance - Contractionary


Are not aligned with the ‘neutral’ level.

Real Monetary Conditions –

Overvalued domestic currency

Expensive credit

Demand and Inflation –


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Policy Frameworks and Transmission Mechanism - 1

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Selecting Diagnostic Tools

To diagnose monetary policy stance…

Decide which tools are better suited for a given policy framework.

Draw the relation between diagnostic tools and the policy transmission mechanism.





Monetary Policy Frameworks Around the Globe

Source: Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), 2016





Impossible Trinity Informs the Choice of the Framework – 1





















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Policy Frameworks and Transmission Mechanism - 2

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Policy Transmission

Channels of Transmission:Asset price

(1) Wealth and (2) Cost of equity

Credit(1) Bank lending and (2) Balance sheet

Interest rate

Exchange rate





Transmission Mechanism – Autonomous Monetary Policy

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Transmission Mechanism – No Autonomous Monetary Policy

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Classifying Diagnostic Tools

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Diagnostic Tools – 1

Two levels of evaluation:

Operating and intermediate targets

Aggregate real monetary conditions





Tools presented:

Forward-looking version of the Taylor Rule

Money overhang and money targets

Real monetary conditions index (MCI)





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Forward-looking Taylor Rule

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Taylor Rule

Taylor’s original parametrization:

tttt yi ˆ5.0)2(5.02 +−++= ππ

Actual InflationShort-term Trend Real Interest Rate

Inflation Target

Policy Shock

CB or short-term Interest Rate Output Gap

ttttt yccri επππ ++−++= ˆ)( 21




Inflation Forecast Targeting

CB implements flexible inflation forecast targeting:Inflation forecast is an intermediate target.

“Flexible” in that…

CB smooths the economic cycle

Lets the actual inflation temporarily deviate from the target.





eNtt

nt ri ++= π

Forward-looking Version of the Taylor Rule

ittt

eNt

nttt yggigigi εππ ++−+−+= +− }ˆ)(){1( 32111

Deviation of expected inflation from the objective

“Neutral” level of the nominal interest rate Output Gap

Expected Inflation

“Neutral” (equilibrium) Real Interest Rate

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Forward-looking Taylor Rule in Excel

Excel


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Money Overhang and Money Targets

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Money Overhang and Money Targets





Equation of Exchange

…in logs and rearranged for real balances:

When y and v are in equilibrium:

PYMV =

vypmmR −=−=

vym R −=

Money Price Level OutputVelocity





Long-Run Target and Overhang

The long-run money growth objective:

Money overhang: The Deviation….

indicates inflationary pressures going forward

π+∆−∆=∆ vym

)()()(ˆ ttttR

tRt

Rt vypmmmm −−−=−=

0ˆ >Rtm





Short-Run Target

CB sets the short-run intermediate objective for the next period:

the CB should restrict money growth below

if the CB has to tighten policy instruments to slow money growth

Rt

St mmm ˆ1 −∆=∆ +

⇒> 0ˆ Rtm m∆

⇒∆>∆ +Stt mm 1

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Money Overhang and Money Targets in Excel

Excel


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Monetary Conditions Index - 1

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Macroeconomics Diagnostics (MDSx)





Real Monetary Conditions Index

ttt qrRMCI ˆ )1(ˆ αα −+≡

Real Interest Rate Gap

Real Exchange Rate Gap

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Measuring Real Interest Rate

The Fisher Equation:

eNttt ir +−= π

Real interest rate Nominal interest rate Expected inflation





0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Real Interest Rate (in percent)

rr rr-bar

Source: Haver Analytics, Fund staff calculations

Real Interest Rate Gap – 2

Contractionary Conditions Accommodative Conditions

ttt rrr −=ˆReal Interest Rate Gap Equilibrium (“neutral”) Level

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Monetary Conditions Index - 2

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Measuring Real Exchange Rate

Bilateral Real Exchange Rate (RER):

In natural logs…

Nominal Exchange Rate in units of FC

per 1 unit of LC

Domestic Price Level

Foreign Price Level

ft

ttt P

PEQ =

ftttt ppeq −+=





Real Exchange Rate Gap

ttt qqq −=ˆ

-380.0

-370.0

-360.0

-350.0

-340.0

-330.0

-320.0

-310.0

-300.0

-290.0

Real Exchange Rate (in percent)

q q-bar

Source: Haver Analytics, Fund staff calculations

Strong domestic currency Weak domestic currency

Real Exchange Rate Gap Equilibrium Level





Aggregation

ttt qrRMCI ˆ )1(ˆ αα −+≡

Real InterestRate Gap

Real ExchangeRate Gap

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Real Monetary Conditions in Excel

Excel


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What is seen in Diagnostica

Conversation

MDSx

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Wrapping Up Monetary Policy

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Module Wrap-Up

The Diagnostic Tools applied:

Forward-looking version of the Taylor Rule

Money overhang and money targets

Monetary Conditions Index (MCI)

Documents

Macroeconomic Diagnostics ( MDSx) Module 5...Required Negative Space (Not for instructor notes.) Please do not adjust text field positions. Ultimate Objective of Monetary Policy Low