Macroeconomics for FinanceJoanna Mackiewicz-Łyziak

Lecture 3

Literature

• Mishkin F., The Economics of Money, Banking, and Financial Markets, ch. 17

• Walsh C.E., Monetary Theory and Policy, 2nd edition, ch. 8

• Svensson L.E.O., “Monetary policy and macroprudential policy: Different and separate”, paper presented at the conference “Macroprudential monetary policy,” Federal Reserve Bank of Boston’s 59th Economic Conference, Federal Reserve Bank of Boston, October 2-3, 2015. Forthcoming in Canadian Journal of Economics.

Policy instruments

• What we already know:

• Central banks use policy instruments – variables that can be directly affected by the monetary policy tools, and intermediate targets – variables that are affected by policy instruments and are directly linked to the ultimate goals. Their achievement signals the central banks’ commitment to the ultimate goal.

• We have discussed policy instruments – reserve aggregates (monetary base) and short-term interest rate (money market rate).

• But can the central banks target monetary base and interbank rate at the same time?

Targeting the nonborrowed reserves

Source: Mishkin, p. 458

Targeting the interbank rate

Source: Mishkin, p. 459

Criteria for choosing the policy instrument

• Observability and measurability• Policy instrument is useful only if it signals the policy stance rapidly.• Reserve aggregates are easily measured but with some lag.• Short-term interest rates are easy to measure and immediately observable (however,

nominal vs. real interest rates).

• Controllability• Reserve aggregates are not completely controllable.• Short-term interest rates are controlled very tightly (but, again, nominal vs. real

interest rates!)

• Predictable effect on goals• In recent years the dominant view is that the link between interest rates and goals

(such as stable inflation) is stronger than between aggregates and inflation.

Communication

• By announcing its reference interest rate the central bank usually signals to the public its target interbank interest rate and implicitly commits to run OMOs in such a volume to meet the target interest rate.

• The announcement influences the markets which adjust to the new interest rate (we can illustrate this as a shift of the demand curve for reserves).

• The official central bank interest rates and the market rates are strictly correlated. When the central bank lowers interest rate, the market interest rates decrease; when the central bank rises interest rate, the market interest rates increase.

• If the communication of interest rate target is effective the central bank has to run less OMOs to achieve the target.

Example: ECB interest rates and EONIA

Taylor rule

• How the central banks choose the target interest rate?

• A simple answer to this question provided John Taylor (John Taylor, 1993. „Discretion versus Policy Rules in Practice.” Carnegie Rochester Conference Series on Public Policy 9(4), 195-314). He proposed a simple rule for monetary policy, stating that monetary policy should respond to the deviations of inflation from the inflation target (inflation gap) and to the percentage deviation of real GDP from an estimate of its potential full employment level.

• According to the Taylor rule the central banks care not only about inflation but also stabilize output.

Taylor rule

• The original Taylor rule can be written as follows (for the Fed):

Federal funds rate target= inflation rate + equilibrium real fed funds rate +

½(inflation gap) + ½(output gap)

• Taylor has assumed that the equilibrium real fed funds rate is 2% and that anappropriate target for inflation would also be 2%, with equal weights of ½ on the inflation and output gaps.

𝑖𝑡∗ = 𝜋𝑡 + 2%+ 1 2 (𝜋𝑡−2%) + 1 2𝑦𝑡

Taylor rule• For the USA Taylor showed that the rule is a good empirical description for the

Fed’s monetary policy.

Taylor rule

• The Taylor rule works well for many central banks.

• It’s specification evolved over time:• Some authors suggested that it should include forecasted rather than current values of

macroeconomic variables (Clarida et al. 1998, 2000; Batini, Haldane, 1999)

𝑖𝑡∗ = 𝑖∗ + 𝛼(𝐸[𝜋𝑡,𝑘|𝛺𝑡] − 𝜋∗) + 𝛽𝐸[𝑦𝑡,𝑙|𝛺𝑡]

• Common assumption made in estimating Taylor rules is that the central banks smooth the interest rate path (Judd and Rudebusch, 1998)

𝑖𝑡 = 𝜌𝑖𝑡−1 + (1 − 𝜌)𝑖𝑡∗

𝑖𝑡 = 𝜌𝑖𝑡−1 + 1 − 𝜌 𝛾 + 𝛼𝜋𝑡+𝑘 + 𝛽𝑦𝑡+𝑙 + 𝜀𝑡

Taylor rule

• It is argued that for open economies the Taylor rule should include additional variables, such as the exchange rate and the foreign interest rate (Ball, 1999; Svensson, 2000; and Taylor, 1999)

𝑖𝑡 = 𝜌𝑖𝑡−1 + 1 − 𝜌 𝛾 + 𝛼𝜋𝑡+𝑘 + 𝛽𝑦𝑡+𝑙 + δ𝑥𝑡

• Current approach in empirical studies on the Taylor rules assumes that the weights on the inflation and output gaps, the equilibrium real interest rate and the smoothing parameter are not constant but may change over time.

• Advantages of the Taylor rule: very simple and transparent, empirically robust, compatible with different economic views of monetary policy, combines inflation targeting with stabilizing policy

• Disadvantages: measurement problems

Taylor rules in EME’s

Source: Mohanty M.S., Klau M., 2004, Monetary policy rules in emerging market economies: issues and evidence,BIS Working Papers No. 149.

Taylor rule – a global Great Deviation?

Source: Hofmann B., Bogdanova B., 2012, Taylor rules and monetary policy: a global „Great Deviation”?, BIS Quarterly Review,September 2012.

Intermediate targets

• The choice of intermediate target depends on the strength of its link to the final goal (of price stability).

• In the 1970s many countries adopted monetary targeting with some monetary aggregate as the intermediate target. Monetary policy was conducted with the aim of achieving the target growth rate of the monetary aggregate.

• In 1990s many countries abandoned monetary targeting, as its link to price stability weakened.

Intermediate targets – Bundesbank and monetarytargeting

• Bundesbank was the first central bank which adopted monetary targeting (together with the Swiss National Bank).

• The intention was to control inflation through the control of monetary expansion. Bundesbank tried to provide guidance to agent’s expectations through the announcement of a quantified objective for monetary growth.

• The Bundesbank formulated its target in terms of a monetary aggregate, called central bank money stock (defined as currency in circulation plus the required minimum reserves on domestic deposits). In 1988, the Bundesbank switched targets from central bank money to M3.

• The Bundesbank did not attempt to control the money stock directly, but followed an indirect approach of influencing money demand by varying key money market rates and bank reserves.

• The Bundesbank made it clear that it could not and would not promise to reach the monetary target with any degree of precision.

Bundesbank money growth targets 1975-1998

Source: Beyer et al. (2009), Opting out of the great inflation. German monetary policy after the break down of Bretton Woods,ECB Working Paper 1020

Inflation in Germany and the US

Source: Beyer et al. (2009), Opting out of the great inflation. German monetary policy after the break down of Bretton Woods,ECB Working Paper 1020

Inflation targeting

• Given the breakdown of the relationship between monetary aggregates and inflation, many countries have adopted inflation targeting as their monetary policy regime.

• The first country to formally adopt inflation targeting was New Zealand in 1990, followed by Canada in 1991, the United Kingdom in 1992, Sweden and Finland in 1993.

• Inflation targeting involves several elements:1. Public announcement of medium-term numerical targets for inflation;2. An institutional commitment to price stability as the primary, long-run goal of monetary

policy and a commitment to achieve the inflation goal;3. An information- inclusive strategy in which many variables are used in making decisions

about monetary policy;4. Increased transparency of the monetary policy strategy through communication with the

public and the markets about the plans and objectives of monetary policymakers;5. Increased accountability of the central bank for attaining its inflation objectives.

Inflation targeting

• The key issue for success of inflation targeting is the ability of the central banks to manage inflation expectations of the economic agents.

• The numerical inflation target serves as a nominal anchor for the economy (and hence, inflation expectations should be anchored in the inflation target)

• Therefore, the critical issue in inflation targeting is credibility of monetary policy.

• The institutional design of inflation targeting central banks – with formal independence of central banks, increased transparency, communication and accountability – is aimed at increasing credibility of inflation targeting strategy.

Inflation targeting

Advantages of inflation targeting

• Reduction of time-inconsistency problem

• Increased transparency• The goals and limitations of monetary policy• The numerical values of the inflation targets• How the inflation targets are to be achieved, given current economic

conditions• Reasons for any deviations from the targets

• Increased accountability

• Consistency with democratic principles

• Improved performance

Time-inconsistency problem and inflation bias

• Source: Walsh C.E., Monetary Theory and Policy, 2nd edition, ch. 8

• The central bank’s loss function:

(1)

• The central bank desires to stabilize both output and inflation; inflation aroundzero, output around 𝑦𝑛 + 𝑘.• k>0 because of:

• labor-market distortions,

• monopolistic competitive sectors,

• political pressure on the central bank.

• Role for stabilization policy

Time-inconsistency problem and inflation bias

The economy:

• Lucas-type aggregate supply function (nominal wage rigidity, wages are set in advance based on the public’s inflation expectations):

(2)

• Money market equilibrium:

(3)

• The private sector expectations are assumed to be determined prior to the central bank’s choice of a growth rate of the nominal money supply.

• Setting Δ𝑚, the central bank will take 𝜋𝑒 as given.

• The central bank can observe e (but not v) prior to setting Δ𝑚.

• e and v are uncorrelated.

Time-inconsistency problem and inflation bias

The sequence of events:

• Private sector sets nominal wages based on 𝜋𝑒 .

• Then the supply shock (e) is realized.

• Central bank chooses Δ𝑚 (can respond to e).

• The velocity shock v is then realized, and actual inflation and output aredetermined.

• Policy decisions can be made more frequently than are most wage and pricedecisions.

Time-inconsistency problem and inflation bias

Equilibrium inflation

• Substituting (2) and (3) into (1) yields:

• If Δ𝑚 is chosen after observing e, but before observing v, to minimize E(V), FOC for the optimal choice of Δ𝑚:

• Solving for Δ𝑚 yields:

(4)

• Policy is conditional on the realization of the supply shock and on private sectorexpectations of inflation.

Time-inconsistency problem and inflation bias

• Expectations are rational and formed prior to observing e:

• Solving for 𝜋𝑒 yields:

• Substituting this into (4) and using (3) gives expression for the equilibrium rate of inflation under discretion:

Time-inconsistency problem and inflation bias

Results under discretion:

• Positive average inflation rate equal to 𝑎𝜆𝑘.

• This has no effect on output, since the private sector completely anticipates thisrate.

• The size of the inflation bias is increasing in the distortion (k), the effect of a money surprise on output (a), and the weight the central bank places on itsoutput objective (𝜆).

Targeting rules as a solution to the inflationbias• Targeting rules:

• Flexible targeting rules – the central bank cares about output and inflation stabilization, but is penalized for deviations of actual inflation from a specific target level.

• Strict targeting rules – the central bank is required to achieve a specific target outcome, regardless of the implications for its other objectives.

• Flexible targeting rules

• The central bank’s objective is to minimize:

(5)

where 𝜋∗ denotes the socially optimal inflation rate (which may differ from zero), and 𝜋𝑇

the target inflation rate. The parameter h measures the weight placed on deviations from the target inflation rate.

Flexible targeting rules

• Remaining equations of the model as before:

• The sequence of events as before.

• Substituting (2) and (3) into (5) yields:

Flexible targeting rules

• FOC for the optimal choice of Δ𝑚, taking expectations as given, is:

• Solving yields:

(6)

• Assuming rational expectations:

Flexible targeting rules

• Substituting into (6) yields time-consistent money growth rate:

(7)

• If target inflation rate is equal to the socially optimal inflation rate (𝜋∗ = 𝜋𝑇), then:

• Setting h=0 yields the time-consistent discretionary solution without targeting with the inflation bias equal to 𝑎𝜆𝑘.

Flexible targeting rules

Results:

• The targeting penalty reduces the inflation bias from 𝑎𝜆𝑘 to 𝑎𝜆𝑘

1+ℎ, by raising the

marginal cost of inflation.

• The cost of this reduction in the average inflation bias is the distortion that targeting introduces into the central bank’s response to the aggregate supply shock e.

• Under pure discretion, the central bank responds optimally to e.

• Under targeting rule the central bank will respond too little to the supply shock.

Strict targeting rules

• Central bank is required to achieve a specific target outcome.

• Example: strict money growth rate target

• Since the desired rate of inflation is 𝜋∗, it makes sense to set Δ𝑚𝑇 = 𝜋∗, and the public will set 𝜋𝑒 = 𝜋∗.

• If social loss is given by:

Strict targeting rules

• Under a strict money growth rate target it takes the value:

• Under pure discretion, the expected value of the loss function is:

Strict targeting rules

• Difference:

• This can be either negative or positive.

• It is more likely to be negative (strict target superior to discretion) if the inflationbias under discretion 𝑎𝜆𝑘 is large.

• Strict targeting rule ensures that average inflation is 𝜋∗ it eliminates any inflationary bias.

• Discretion is more likely to be preferred to the strict rule when 𝜎𝑒2 is large.

• The strict targeting rule eliminates any stabilization role for monetary policy.

Advantages of inflation targeting

• Reduction of time-inconsistency problem

• Increased transparency• The goals and limitations of monetary policy• The numerical values of the inflation targets• How the inflation targets are to be achieved, given current economic

conditions• Reasons for any deviations from the targets

• Increased accountability

• Consistency with democratic principles

• Improved performance

Disadvantages of inflation targeting

• Delayed signaling• Inflation is not easily controlled

• Inflation outcomes are revealed after substantial lag

• Too much rigidity• But, in practice, it contains a substantial degree of policy discretion

• Potential for increased output fluctuations

• Low economic growth

Inflation targets around the world

Inflation targeting after the global financialcrisis• Level of the inflation targets

• Should inflation targets be higher?

• Flexibility of inflation targeting• Achieving price and output stability does not ensure financial stability

• Central banks need to pay more attention to financial stability

• How central banks should respond to asset-price bubbles?

Should central banks try to stop asset-pricebubbles?• Types of asset price bubbles:

• Credit-driven bubbles

• Bubbles driven solely by irrational exuberance

• Should monetary policy try to pop (or slow) the growth of potential asset-price bubbles? (leaning against asset price bubbles), or

• Should monetary authorities respond only to the asset-price declines that occur after a bubble bursts? (cleaning up after the bubble burst)

• ”Lean vs. clean” debate

Why to clean (”Greenspan doctrine”)

• Asset price bubbles are nearly impossible to identify.

• Raising interest rates may be very ineffective in restraining bubbles or may cause more damage.

• There exist many different asset prices.

• Monetary policy actions to prick bubbles can have harmful effects on the aggregate economy.

• Adequate response of monetary policy after the bubble burst may decrease the harmful effects.

Why to lean

• Bursting of credit driven bubbles can be extremely costly and very hard to clean up.

• Leaning against credit booms instead of leaning against potential asset-price bubbles – credit booms are much easier to identify.

• How to prevent credit booms?• Macroprudential policy

• Monetary policy

Monetary policy vs. macroprudential policy in achieving financial stability• Source: Svensson L.E.O., “Monetary policy and macroprudential policy:

Different and separate”, paper presented at the conference “Macroprudentialmonetary policy,” Federal Reserve Bank of Boston’s 59th Economic Conference, Federal Reserve Bank of Boston, October 2-3, 2015. Forthcoming in Canadian Journal of Economics.

• For monetary policy, under flexible inflation targeting, there are two goals, price stability and real stability, more precisely to stabilize inflation around the inflation target and resource utilization around its long-run sustainable rate.

• For macroprudential policy, the goal is financial stability. A relevant definition of financial stability is that the financial system can fulfill its three main functions (transforming saving into financing, providing risk management, and transmitting payments) with sufficient resilience to disturbances that threaten these functions.

Monetary policy vs. macroprudential policy in achieving financial stability• The instruments of macroprudential policy are supervision, regulation, and

communication. They include capital and liquidity requirements; loan-to-value (LTV) caps; stress tests of banks, other financial institutions, and households; financial-stability reports; and so on.

• The authority or authorities controlling the macroprudential instruments and being responsible for achieving and maintaining financial stability vary across countries and may include the financial supervisory authority, the central bank, the ministry of finance, and other regulatory and supervisory agencies.

• Existing theoretical and empirical evidence suggests that “leaning against the wind” (of asset prices and credit booms), promoted by BIS (2014) and implying the conduct of a somewhat tighter policy than justified by stabilizing inflation around the inflation target and resource utilization around its long-run sustainable rate, is an ineffective and even counterproductive way of promoting financial stability.

Monetary policy vs. macroprudential policy in achieving financial stability• Both policies are needed to achieve both the monetary policy goals of price

stability and real stability and the macroprudential goal of financial stability.

• There is interaction between the two policies.

• Macroprudential policy affects financial markets, spreads between different interest rates, and lending by banks, household borrowing, housing demand, housing prices, and construction. This way it indirectly affects inflation and resource utilization.

• Monetary policy affects interest rates, output and employment, profits, credit losses and assets prices. This way it affects debt service and balance sheets. This way it indirectly, but not systematically, affects financial stability.

Monetary policy in achieving financial stability– Swedish experience• In June 2010, the forecast for inflation and unemployment by the Riksbank for Sweden

and by the FOMC for the U.S. looked very similar. The inflation forecast was below 2 percent and the unemployment forecast was far above each central bank’s estimate of a long-run sustainable rate.

• USA: further easing of monetary policy. The FOMC at the time continued to keep the policy rate close to zero and started preparing QE2.

• Sweden: Riksbank’s executive board raised the policy rate rapidly from 0.25 percent in July 2010 to 2 percent in July 2011, citing concerns about housing prices and household debt.

• As a consequence, unemployment stayed up at around 8 percent and inflation fell (even negative).

• The Riksbank had been forced to reduce the policy rate back to 0.25 percent, with unemployment still at around 8 percent and inflation at zero.

• It also apparently abandoned any attempt to use the policy rate to influence housing prices and household debt.

Monetary policy vs. macroprudential policy in achieving financial stability• A recent IMF staff paper (IMF 2015, “Monetary Policy and Financial Stability,”

Staff Report) presents a thorough analysis and survey of the pros and cons of leaning against the wind and finds that except in the most exceptional circumstances, costs outweigh benefits.

• It concludes that, “[b]ased on current knowledge, the case for leaning against the wind is limited, as in most circumstances costs outweigh benefits.