Monetary Policies and Financial Stability: Recent Development and Lessons from the Current Financial Crisis

Prof. Dr. Stefan Jungblut

20.03.2013

Monetary Policies and Financial Stability: Recent Development and Lessons From

The Current Financial Crisis

Faculty of Business Administration and Economics

Department of Economics


Sherif Elkoumy

Master´s thesis defense in Business Administration


2 20.03.2013

• Introduction • Monetary

policy theory

• Types of

monetary policies

• Inflation

Targeting • Monetary

Policies and Financial stability

• Conclusion

Introduction

Monetary policy theory – Overview

Types of monetary policies

Monetary-aggregate Targeting

Exchange-rate Targeting

Inflation Targeting

Flexible Inflation Targeting

Montary policies and Finacnial stability

Conclusion


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policy theory • Types of

monetary policies

• Inflation



• Conclusion

The monetary policies are the central tool of macroeconomic

stabilization.

Central banks in developed and developing countries have

made great steps in the conduct of monetary policies.

Inflation rates have been decreased to levels that are consistent

with price stability.

Once price stability has been attained, growth rates of the

aggregate economy have been high.

The thesis looks at the recent development of monetary policies

by studying different monetary policies that allow monetary

policy to focus on domestic consideration.


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policy theory

• Types of

monetary policies

• Inflation



• Conclusion

Definition

The role of a nominal anchor

Basic principles of monetary policy

Price stability

Avoiding time inconsistency

Alignment of fiscal policy with monetary policy

Forward looking policy

Accountability

Central bank independency

Central bank accountability


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policy theory

• Types of

monetary policies

• Inflation



• Conclusion

Definition

- A process by which the monetary authority controls and

monitors the money supply.

- It can be either expansionary or contractionary .

The role of a nominal anchor

- A restriction on the value of domestic money. A single

variable central bank use to peg down expectations of

private agents about the nominal price level.

- Two types of nominal anchor

> quantity-based nominal anchor

> price-based nominal anchor


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policy theory

• Types of

monetary policies

• Inflation



• Conclusion

Basic principles of monetary policy

Price stability

- Low and stable inflation rate provides considerable benefits to

the economy.

Avoiding time inconsistency

- Follow short-term objectives results in poor long-term outcomes.

Alignment of fiscal policy with monetary policy

- Irresponsible fiscal policy affects on price stability.

Forward looking policy

- To metigate long lags from monetary policy.

Accountability

- Actions of the government should be publicly monitored.


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policy theory

• Types of

monetary policies

• Inflation



• Conclusion

Central Bank Independence

- The degree of independency affects on the rate of money

expansion and credit. High levels of independence with a

clear mandate for the bank are important to assure price

stability and a better macroeconomic performance.

Central Bank Accountability

- Central bank should be subject to government and public

supervision. Central banks are required to communicate

obviously their monetary policy strategy to illustrate their

targets and goals and how they plan to achieve them.


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monetary policies

• Inflation



• Conclusion


Theoretical framework

Advantages and disadvantages





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monetary policies

• Inflation



• Conclusion



The strategy includes three main elements:

1. Depending on information delivered by a monetary-

aggregate to manage monetary policy.

2. Announcement of targets for monetary-aggregates.

3. Accountability mechanism to exclude large and systematic

deviations from monetary targets.

The strategy focus mainly on the growth of a chosen

monetary-aggregate.


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monetary policies

• Inflation



• Conclusion



1. Authorities reacts quickly to shocks in the domestic

economy.

2. Monetary targeting generates instantaneous signals about

the status of the monetary policy.

3. A solid relationship between the goal and the target

variable must be existed. If this relationship is not

available between income level, price level and the velocity

of money, monetary targets will not be able to convoy

clear signals about the stance of the monetary policy.


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monetary policies

• Inflation



• Conclusion



- The central bank attempts to ensure nominal exchange rate

stability against the currency of a so-called anchor country via

interest rate changes and direct exchange interventions

thereby importing price stability.

- An adequate level of international reserves is required.

- An appropriate economic policy that ensures a low level of

inflation differential against the anchor country.


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monetary policies

• Inflation



• Conclusion



1. The framework fixes inflation rate for internationally

traded goods, and thus directly takes part to keep inflation

under control.

2. It anchors inflation expectation by providing an automatic

rule for the conduct of monetary policy.

3. It avoids the time-inconsistency problem

4. Exchange rate targeting hinders central banks from

establishing an independent monetary policy.

5. Exchange rate targeting is probably to stimulate financial

fragility in emerging markets countries.


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monetary policies

• Inflation



• Conclusion

Theoretical approach

Inflation targeting framework

Assignment of the target

Interaction with other policy

Definition of target

Economic effects of inflation targeting

Drawbacks

Flexible inflation targeting


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monetary policies

• Inflation



• Conclusion

- A practical response to the downfall of the other monetary

policy strategies. Inflation targeting is a credible nominal

anchor for inflation expectations.

Theoretical approach

“..a framework for monetary policy characterized by the public

announcement of official target ranges over one or more time

horizons; low and stable inflation are monetary policy´s primary

long-run goal; vigorous efforts to communicate with the public

about the plans and objectives of the monetary authorities;

mechanisms that strengthen the central bank´s accountability for

attaining those objectives.”


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monetary policies

• Inflation



• Conclusion



Interaction with other policy


• Horizon of the target

• Choice of price index

• Width of the target band

• Accountability

• Inflation forecasts


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monetary policies

• Inflation



• Conclusion



• Who assigns the inflation target – Central bank or Government.

Interaction with other policies

• Full employment (in short-run, a tradeoff between the two

objectives may be occurred, in the long-run, achieving the target

is the best action to full employment objective).

• Financial stability should be compatible with the inflation

targeting framework.

• Fiscal policy objectives. Monetary policy requires considering the

impact of fiscal policy on the outlook for inflation. Similarly, fiscal

policy requires supporting the inflation target.


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monetary policies

• Inflation



• Conclusion



• Horizon of the target (it depends on the inflation rate at

the time of setting inflation target).

• Level of the target (theoretically, zero inflation is equal to

price stability, practically, having inflation target above zero

is preferred).

• Choice of price index (vary due to the different methods

in calculating the CPI and the relative sensitivity of the CPI

inflation rate to supply shocks).


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monetary policies

• Inflation



• Conclusion



• Width of the target band (should it be a numerical

number or a band?).

• Accountability (increased accountability of inflation

targeting allows monetary authority to monitor and improve

the understanding of expectations).

• Inflation forecasts (due to its forward-looking nature,

inflation targeting dynamically uses forecast; therefore, the

central bank´s forecasts of inflation are critical).


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monetary policies

• Inflation



• Conclusion


• Inflation targeting has remained within the targeted range or close

to the target rate.

• Inflation targeting has been successful in controlling inflation.

• Inflation targeting can promote growth and does not lead to

increased output fluctuations.

• Inflation targeting increases accountability which helps

ameliorates the time-inconsistency problem.

• Increased transparency and accountability under inflation

targeting helps promote central bank independence.

• Inflation targeting can help build credibility and anchor inflation

expectations more rapidly and durably.


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monetary policies

• Inflation



• Conclusion


• Inflation targeting grants more flexibility.

• Inflation targeting includes a lower economic cost in the face of

monetary policy failure.

• Effects on inflation (average inflation has decreased on average,

fluctuations in inflation have declined).

• Effects on growth and business cycle variability (a slight increase in

the average growth, growth variability has declined generally).

• Effects in interest rates and exchange rates (a decline in inflation

expectations and the inflation risk premium on nominal interest

rates, real exchange rate variations have declined on average).


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monetary policies

• Inflation



• Conclusion


• The performance of inflation targeting strategy over the past 20 yrs.

Inflation and growth performance (Roger, 2010)

Output and inflation smooth (Roger, 2010)


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monetary policies

• Inflation



• Conclusion

Drawbacks

• September 2008, central banks that had been depending on

inflation targeting have not given enough consideration to assets-

price bubbles.

• improper responses to supply shocks and terms-of-trade shocks.

• Inflation targeting cannot work in countries that do not meet a

stringent set of preconditions.

Flexible inflation targeting

• Set weight on real GDP growth in the short-run, so long as there is a

clear longer-term target for CPI inflation.

• Inflation targeting should not be a strict inflation targeting but a

flexible inflation targeting.


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monetary policies

• Inflation



• Conclusion

The relationship between monetary policy and financial

stability

• Inflation can be viewed as one of the major factors creating

financial stability in the first place.

• Monetary policy and financial stability policy are inherently

connected to one another .

Assets price bubbles

• Asset price movements and asset price bubbles can directly

endanger financial stability.

Lessons from the crisis

• Price stability is not enough to attain financial stability and good

flexible inflation targeting by itself does not attain financial

stability.


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monetary policies

• Inflation



• Conclusion

• Inflation targeting clearly outperforms both monetary-

targeting and exchange-rate regime. While the latter suffers

from many drawbacks, the former shows an improved

performance in terms of inflation reduction and economic

conditions.

• To overcome these severe drawbacks, inflation target should

be flexible and gives some weight on real GDP growth in the

short-run, so long as there is a clear longer-term target for CPI

inflation.

• flexible inflation targeting does use all information that is

relevant for the forecast of inflation and resource utilization.


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Documents

Monetary Policies and Financial Stability: Recent Development and Lessons from the Current Financial Crisis