1 stabilising the economy: central banks and monetary policy msc eps session 4 hilary term 2013...
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Stabilising the economy: Central Banks and Monetary
Policy
MSc EPS Session 4Hilary term 2013
Professor 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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OUTLINE
Price stability defined
Why is price stability important?
Role of Central Bank – a broader remit than price stability?
Monetary policy – objectives and instruments
Effectiveness of monetary policy
New thinking on banking and central banks
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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)
Why not CPI target of 0%?
Composition bias
Quality bias Substitution bias
Importance of “medium term” – Bank must not overreact to short term upsurge
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WHAT CAUSES INFLATION?
Inflation is always and everywhere a monetary phenomenon (Friedman)
Demand shocks (property price boom)
Supply shocks (food, energy price increase)
Budget deficit
Money supply, increase in loans
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ECONOMIC COSTS OF INFLATIONpp 284-286
Inefficiency effects
Redistributive wealth effects
Adverse dynamics – inflationary spiral
Costly to restore price stability
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Deflation also a problem
Can be even more damagingthan inflation
Can you explain why?
QUESTION FOR CLASS DISCUSSION
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TASKS OF CENTRAL BANK
Monetary policy
Official foreign reserves
Exchange rate defence
Lender of last resort
Government banker
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THE CENTRAL BANK
Price stability – ultimate objective
Intermediate variables to monitor:
Money supply
Growth of credit
Capacity utilisation
Commodity pricesOrder books
Exchange rate
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Speech given by Mervyn King, Governor Bank of England, Belfast 22 January 2013
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THE CENTRAL BANK (2)
Price stability – ultimate objective
…. and , by adhering to this objective ,
Central Bank will make maximum contribution to overall
macroeconomic stability.
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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
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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
pp318-333
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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
ECB BoE US
ECB: main refinancing rateBoE: official bank rateFed: target rate 16
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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 (-) S, (+) C
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 (+) C (+) I
4. Cost of Capital (Investment) effect (-) i (+) I
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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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Tighten monetary policy
Fig 13.6 p 321
HOW MONETARY POLICY COMBATS INFLATION
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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 in dealing with Deflation
• Nominal interest rate cannot go below zero (ZIRP)
• When prices are falling, real interest rate can stay high even as nominal rate falls
• Hence monetary policy may not have sufficient stimulative impact to combat recession
• FUNDAMENTAL LIMITATION: expansionary monetary policy encourages spending --- but it cannot force people to borrow and spend
(Also potential danger of overstimulus causing inflation)
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Reform of the Financial Sector also needed
1. “Too big to fail” banks must be taxed to compensatetaxpayer for implicit government guarantee:“specific capital surcharges for systemically important financial institutions can be a useful tool and should be accompanied by resolution plans vetted by regulators” (OECD).2. Structural separation between retail and investmentbanking also needed 3. Reduce incentive to get too big to fail by taxing the equivalent of the implicit guarantee.4. Improve supervision and incentives system
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Quantitative Easing
a)What is it?
b) Can it help to restore credit growth?
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Limitations of monetary policy in dealing with Inflation
• High nominal interest rate may be needed to curb over optimism and restore balance
• Danger or over reaction to short term price changes
• Insufficient attention to asset price movements
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1. Define price stability. Why is attainment of price stability important?
2. What intermediate targets can a central bank set to ensure that price stability is maintained?
3. What policy actions can a central bank take to preserve price stability?
4. Would a cut in interest rates be an effective way of stimulation aggregate demand in the Euro Area?
5. Does business prefer rising prices (inflation) to falling prices (deflation)?
Or are both equally undesirable? Explain.
Questions for Group work
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Exercise 3 p. 304
Questions for Group work (2)
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CONCLUSIONS
Price stability is good for economic growth
Deflation is just as damaging as inflation
Aggressive monetary policy necessary to avoid booms and busts
But not always sufficient ...
In times of crisis, fiscal policy also needed
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G20 COMMUNIQUE LONDON APRIL 2009
Monetary Policy in Action
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G20 COMMUNIQUE LONDON APRIL 2009