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Stabilising the economy: Central Banks and Monetary

Policy

Topic 4MSc EPs

Hilary term 2011Professor Dermot McAleese

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Aim of economic policy is to reduce volatility of market

economy

GDP

GDP with counter-cyclical policy

time

GDP withoutcounter-cyclical policy

Potential GDP

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PRICE STABILITY AND THE CENTRAL BANK

Price stability defined

Why is price stability important?

Role of Central Bank

Monetary policy – objectives and instruments

Effectiveness of monetary policy

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Latin American Inflation, average annual rates

Source: IMF, World Economic Outlook, successive issues; Bank of International Settlements, 64th Annual Report, Basle 2000.

1980-85 1986-90 1991-2000

2001-04 Peak rate since 1970

Chile 21.3 19.3 8.5 3.1 505 (1974)

Bolivia 611.0 46.5 12.7 2.1 11705 (1985)

Mexico 60.8 69.6 15.2 4.7 132 (1987)

Argentina 322.5 584.0 9.0 15.0 4924 (1989)

Brazil 149.0 657.5 434.2 8.7 2407 (1994)

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Price Stability

a rise in the general level of prices below, but close to, 2% over the medium term

(ECB May 2003)

Consumer Price Index (CPI)

Sources of measurement bias

Composition bias

Quality bias

Substitution bias

Note: Should asset prices be included in CPI?

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WHAT CAUSES INFLATION?

Inflation is always and everywhere a monetary phenomenon (Friedman)

Demand shocks (property price boom)

Supply shocks (oil, energy price increase)

Budget deficit

Money supply

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WHAT CAUSES DEFLATION?

Demand shocks (property price fall; stock exchange collapse)

Supply shocks (interest rate increase) Budget surplus

Money supply – credit reduction

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ECONOMIC COSTS OF DEFLATION(DMcA pp 284-286)

Inefficiency effects

Redistributive wealth effects

Adverse dynamics – deflationary spiral

Costly to restore price stability

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Fisher’s Paradox

The more debtors pay, the more they owe.

(the chief secret of most if not all great depressions)

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JAPAN’S DEFLATION (Box 12.1 pp 290-291)

Land prices and commercial property fall by 50% 1990-1995. Commercial estate prices fall 87% in real terms (Koo, 258)*

Nikkei index falls from 38,900 in 1989 to under 10,000 (just over 7.000 in March 2009)

Consumers prices decline

“Adverse dynamics” dominant

Combination of debt and deflation ‘a lethal cocktail’. Balance sheet recession

‘Zero interest floor’ problem

* Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 2009

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Japan's Deflation 1995-2010

-2.0

-1.0

0.0

1.0

2.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CPI data, taken from World Bank, OECD

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TASKS OF CENTRAL BANK

Monetary policy Lender of last resort --

preservation of financial system

------------------------------ Exchange rate defence Manage official foreign reserves Government banker

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THE CENTRAL BANK

Price stability – ultimate objective

Intermediate targets

Money supply

Inflation ‘lead’ indicators

Exchange rate

Employment, economic growth?

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Objective European Central Bank (ECB)

Primary objective of the Eurosystem is to

maintain price stability.

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TASKS of Federal Reserve Bank

Objective is “to attain maximum employment, stable prices and moderate long term interest rates”.

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Euro Area’s Money Supply June 2009 (€bn)

• Currency in circulation• Overnight deposits

Narrow Money (M1)

• Short-term Deposits (Quasi-Money)

• Money Supply (M3)

735 3,505

€4,240

5,190

€9,430bn Memo: GDP 2008 = €9,200 bn

Source: ECB Monthly Bulletin M3 at june 2010 is €9,419 bn ECB Sep 2010

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ACHIEVING PRICE STABILITY

Political commitment

Institutional framework

Independent Central Bank

Clear policy objective

Fiscal sustainability

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European Central Bank (ECB)

Neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body.

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POLICY INSTRUMENTS OF CENTRAL BANK

Open market operations

Interest rate

Minimum reserve ratio----------------------------------------- Intervention in forex markets

Direct controls --------------------------------------------

Unconventional measures

DMcA pp318-333

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Banknotes No of notes

(m)Value (€bn)

€5 1,300 6

€10 2,000 20

€20 2,250 45

€50 4,500 220

€100 1,200 120

€200 150 30

€500 480 240

Euro banknotes in circulation December 2007 (€677bn)

Source: computed from ECB Annual Report 2007

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Central Bank Policy Instruments since 2007

More More Bail-outs,counter- liberal Longer Forex Foreign Private Gov't capitalparties collateral term Swaps Exchange Equities debt debt injections

Australia √ √ √

Britain √ √ √ √ √ √

Canada √ √ √ √ possible possible

Euro area √ √ √ possible possible

Japan √ √ √ √ √ possible

Sweden √ √ √ √

Switzerland √ √ √ √

United States √ √ √ √ √ √ √

China

Source: Economist April 2009; DMcA estimates

Outright purchasesLending Operations

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Key Policy interest rate

0.001.002.003.004.005.006.007.00

01/0

1/20

00

01/0

1/20

01

01/0

1/20

02

01/0

1/20

03

01/0

1/20

04

01/0

1/20

05

01/0

1/20

06

01/0

1/20

07

01/0

1/20

08

01/0

1/20

09

ECB

BoE

US

ECB: main refinancing rateBoE: official bank rateFed: target rate

23EEAG report feb 2010 (updated)

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INTEREST RATES AND ECONOMIC ACTIVITY (pp 315-318)

THE MONETARY TRANSMISSION MECHANISM

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MONETARY POLICY AND REAL GDP1. Substitution effect (-) i (-) Saving, (+) Consumption

2. Cash flow (income) effect (-) i (+) cash flow of borrowers (-) i (-) cash flow of lenders

3. Wealth effect(-) i (+) in value of property and equities (+) Consumption (+) Investment

4. Cost of Capital (Investment) effect (-) i (+) Investment

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MONETARY POLICY AND REAL GDP

5. Exchange rate effect

(-) i depreciation of real exchange rate

6. CB credibility effect

(-) i (+) domestic confidence

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Relax monetary policy

Higher money base

Lower interest rate

Growth in private sector credit

More spending

Consumer price increase

Asset price boost?

More output in short run

Price stability and economic recovery More at work

Fig 13.6 p 321

HOW MONETARY POLICY COMBATS DEFLATION

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If actual output > potential output, restrictive monetary policy will

reduce dangers of inflation

Objective is to secure a soft landing ….

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If actual output < potential output, expansionary monetary policy will

reduce danger of deflation

Objective is to secure price stability…

Need for reflation, or “mild” inflation to solve private debt trap?

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Limitations of monetary policy

• Nominal interest rate cannot go below zero (ZIRP)

• When prices are falling, real interest rate can stay high even as nominal rate falls

• Monetary policy encourages spending but cannot make it happen

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1. Define price stability. Why is attainment of price stability important?

2. What policy actions can a central bank take to prevent deflation?

3. Can the use of monetary policy on its own cure a recession? What are the limits to its effectiveness?

4. Q 3 p. 303 --- does business prefer rising prices to falling prices?

5. What actions if any should the ECB take to reduce the Euro area’s high unemployment rate?

Questions for Group work

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You can tell whether a man is clever by his answers.You can tell whether a man is wise by his questions.

Naguib Mahfouz Nobel Prize for Literature 1988

Exercise 5 p. 332

During 2003-4, as nominal interest rates fell to near zero, there was much discussion of the need for central banks to have recourse to ‘unconventional measures’ in order to stimulate aggregate demand. These measures included:

a) Direct increases of the monetary baseb) Purchase of corporate debtc) Purchase of government bonds to reduce long term interest

ratesd) Buying private securities to boost asset pricese) Explicit commitment to higher inflation target of 3 per cent.

Analyse how each of these measures might be expected to impact on aggregate demand.

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CONCLUSIONS

Price stability is good for economic growth

Deflation is just as damaging as inflation

Aggressive monetary policy required to prevent deflationary adverse dynamics taking hold

In times of crisis monetary policy not enough on its own. Expansionary fiscal policy also needed

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G20 COMMUNIQUE LONDON APRIL 2009

Monetary Policy in Action

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Monetary Policy not enough ….

…….. in current conditions monetary policy will be insufficient.

This is a Keynesian situation that requires Keynesian remedies. Budget deficits will end up at levels previously considered unimaginable.

Martin Wolf Financial Times Wed 22 Oct 2008

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OECD Economic Outlook Nov 2009 p. 38