Monetary Economics (ECS3701) 24 - Monetary Policy Theory

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ECS 3701Monetary Economics

Errol Goetsch 078 573 5046 [email protected] 082 770 4569 [email protected]

www.facebook.com/groups/ecs3701

Boston | UNISA 201524: Monetary Policy Theory

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Part 1 – Introduction01 Why study money, banking, financial markets02 Overview of the financial system03 What is Money?Part 2 – Financial Markets04 Understanding interest rates05 The behaviour of interest rates06 The risk and term structure of interest ratesPart 3 – Financial Institutions08 An economic analysis of financial structure09 Financial crises in advanced economies10 Financial crises in emerging economies11 Banking and management of financial institutionsPart 4 – Central banking and monetary policy14 Central banks: a global perspective15 The money supply process16 Tools of monetary policy17 The conduct of monetary policy: strategy and tacticsPart 6 – Monetary theory20 Quantity theory, inflation and demand for money21 The IS curve24 Monetary policy theory25 The role of expectations in Monetary Policy26 Transmission mechanisms of Monetary Policy

Goals24.1 Response of Monetary Policy to shocks24.1.1 Demand Shocks24.1.2 Permanent Supply Shocks24.1.3 Temporary Supply ShocksApplication: Quantitiative (Credit) Easing24.2 Active vs Passive Stabilisation Policy24.2.1 Lags24.3 Causes of Inflationary Policy24.3.1 Cost-Push Inflation24.3.2 Demand-Pull Inflation24.3.3 Raising the Inflation Rate24.4 Inflation Overview24.4.1 Definition and Measurement24.4.2 Impulses vs Spirals24.4.3 Money and Inflation24.4.4 Social conflict and Inflation Proneness24.4.5 Combating Inflation24.4.6 The Cost of InflationExamine the role of monetary policy in creating inflation

and stabilizing the economyAddress the question of whether monetary policy should be activist or passive

Monetary EconomicsParts 1 - 6

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Goods Market

Buy

Sell

Price

Price

Sell

Buy

Make

Use

Price

Price

Imports

Exports Exports

Imports

CPI

PPI

Une

2 Inflation1 Unemployment

U%

EAP

5 Equality

Lorenz Curve

Gini Coefficient

4 Business Cycles

Trough ↑swing Peak ↓swing

GDPGNI

4 Growth

Consumers

24.1 Response of Monetary Policy to Shocks

Supply

Demand

Macroeconomic Objectives1. Full employment2. Price Stability3. External Equilibrium4. Economic growth5. Equitable income

Factor Market

Producers

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24.1 Response of Monetary Policy to Shocks

• Monetary policy should try to minimize the difference between inflation and the inflation target

• In case of both demand shocks and permanent supply shocks– policy makers can simultaneously pursue price stability and

stability in economic activity

• Following a temporary supply shock– policy makers can achieve either price stability or economic

activity stability, but not both– this tradeoff poses a dilemma for central banks with dual

mandates

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24.1.1 Response to an Aggregate Demand Shock

• Policy makers can respond to this shock in 2 possible ways:1. no policy response

2. policy stabilizes economic activity and inflation in the short run

• In the case of aggregate demand shocks:– no tradeoff between the pursuit of price stability and

economic activity stability

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24.1.1 Aggregate Demand Shock: No Policy Response

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24.1.1 Aggregate Demand Shock: Policy Stabilizes Output and Inflation in Short Run

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24.1.1 APPLICATION Quantitative (Credit) Easing in response

1. Sometimes the negative aggregate demand shock is so large that at some point the central bank cannot lower the real interest rate further because the nominal interest rate hits a floor of zero

2. This occurred after the Lehman Brothers bankruptcy in late 2008

3. In this situation when the zero-lower-bound problem arises, the central bank must turn to nonconventional monetary policy

4. Though the Fed took action, the negative aggregate demand shock to the economy from the global financial crisis was so great that the Fed’s quantitative (credit) easing was insufficient to overcome it

5. The Fed was unable to shift the aggregate demand curve all the way back and the economy still suffered a severe recession

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24.1.2 Response to a Permanent Supply Shock

• Two possible policy responses to a permanent supply shock:

-no policy response

-policy stabilizes inflation

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24.1.2 Permanent Supply Shock: No Policy Response

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24.1.2 Permanent Supply Shock: Policy Stabilizes Inflation

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24.1.3 Response to Temp Aggregate Supply Shock: No Policy Response

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24.1.3 Response to Temp Aggregate Supply Shock: Short-Run Inflation Stabilization

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24.1.3 Response to Temporary Supply Shock

• When a supply shock is temporary, policymakers face a short-run tradeoff between stabilizing inflation and economic activity

• Policymakers can respond to the temporary supply shock in three possible ways:1. No policy response

2. Policy stabilizes inflation in the short run

3. Policy stabilizes economic activity in the short run

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24.1.3 Response to Temp Aggregate Supply Shock: Short-Run Output Stabilization

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24.1 Summary: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity

• We can draw the following conclusions1. If most shocks to the economy are aggregate demand

shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, even in the short run

2. If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run

3. In the long run there is no conflict between stabilizing inflation and economic activity in response to shocks

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24.2 How Actively Should Policy Makers Try to Stabilize Economic Activity?

• All economists have similar policy goals (to promote high employment and price stability)

• They often disagree on the best approach to achieve those goals– Nonactivists believe government action is unnecessary to

eliminate unemployment– Activists see the need for the government to pursue active

policy to eliminate high unemployment when it develops• Many activists argued that the government needed to do more

by implementing a massive fiscal stimulus package• On the other hand, nonactivists opposed the fiscal stimulus

package, arguing that fiscal stimulus would take too long to work because of long implementation lags

• The Obama administration came down squarely on the side of the activists and proposed the American Recovery and Reinvestment Act of 2009, a $787 billion fiscal stimulus package that Congress passed on February 13, 2009

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24.2.1 Lags and Policy Implementation

• Several types of lags prevent policymakers from shifting the aggregate demand curve instantaneously:– Data lag: the time it takes for policy makers to obtain data

indicating what is happening in the economy – Recognition lag: the time it takes for policy makers to be sure

of what the data are signaling about the future course of the economy

– Legislative lag: the time it takes to pass legislation to implement a particular policy

– Implementation lag: the time it takes for policy makers to change policy instruments once they have decided on the new policy

– Effectiveness lag: the time it takes for the policy actually to have an impact on the economy

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24.3 Causes of Inflationary Monetary Policy

Friedman

Demand-pull caused by high rate of money growth

Mishkin

High Employment Targets and Inflation

Cost-push inflation results either from a temporary negative supply shock or a push by workers for wage hikes beyond what productivity gains can justify

Demand-pull inflation results from policy makers pursuing policies that increase aggregate demand

Study Guide

Social conflict over real incomes / goods by Government, business or labour who seek to protect or increase their claims by continuously imposing cost increases on others

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24.3.1 Cost-Push Inflation

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24.3.2 Demand-Pull Inflation

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24.3.3 A Rise in the Inflation Target

monetary policy makers can target any inflation rate in the long run by shifting the aggregate demand curve with autonomous monetary policy

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Buy

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Buy

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Imports

Exports Exports

Imports

CPI

PPI

2 Inflation

monetary policy makers can target any inflation rate in the long run by shifting the aggregate demand curve with autonomous monetary policy

GDP deflator comprehensive, but slow and unstable;

Producer Price Index next popular alternative- index that measures ΔP of imported and produced goods at first trade- includes capital and intermediate goods- excludes services- imported goods counted on arrival in country- produced goods counted at exit from family- acts as a predictor of CPI- weghtings differ from CPI

Consumer Price Index most popular alternative- index that measures changes in price of (a basket of) goods and services bought by an average consumer / household over time- made up of categories of spend that have own price changes- each category has a weighting- changes in price produce an annual % change in CPI

Goods Market

Price

Price

Price

Price

Factor Market

Producers

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24.4.1-3 Inflation: A sustained and general price increase“Always and Everywhere a Monetary Phenomenon”

Demand impulse

ΔMd

Supply impulse =>

spiralΔMd

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Buy

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Imports

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PPI

2 Inflation

Prone to inflation if

1. Regular faces sudden significant increases in input costs2. Major sectors strong enough to protect real income by passing on costs Government vs. Tax payers Business vs Consumers Unions vs Unemployed3. Money stock is highly elastic Money is fiat SARB accomodates demand4. Exchange rate weakness

Non-inflationary ScenarioFully-inflationary ScenarioPartially Inflationary Scenario

Goods Market

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Price

Price

Price

Factor Market

Producers

Consumers


24.4.4 Causes of InflationSocial Conflict and Tendency towards Inflation

Demand

Supply

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Buy

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Sell

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Imports

Exports Exports

Imports

CPI

PPI

2 Inflation

Supply-side

Producers become more productiveMarkets become more competitiveInput prices more stableImport prices reduce in absoluite termsMoney supply less elasticSocial contract

Demand-sideReal sacrificesSocial contractPrice controlsTight monetary policy (high interest rates)Foreign sector accomodation (Rand strength)

Reducing inflationary expectations

Goods Market

Price

Price

Price

Price

Factor Market

Producers

Consumers


24.4.5 Combating Inflation:Supply side and Demand side actions

Demand

Supply

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Buy

Sell

Sell

Buy

Make

Use

Imports

Exports Exports

Imports

CPI

PPI

2 Inflation

Damages productivity- creates uncertainty, reduces investment- creates instability and pessimism, reducing investment- diverts resources from production to safety

Goods Market

Price

Price

Price

Price

Factor Market

Producers

Consumers


24.4.6 Costs of Inflation:For producers and consumers

Demand

Supply

Distorts incomes- stresses the weakest, without means to protect purchasing power- stresses the unbanked, or holders of wealth in money- hurts creditors with cheapened repayments- hurts taxpayers, who creep into higher tax brackets + CGT- hurts foreign investors, who recover in cheaper Rands

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Part 1 – Introduction01 Why study money, banking, financial markets02 Overview of the financial system03 What is Money?Part 2 – Financial Markets04 Understanding interest rates05 The behaviour of interest rates06 The risk and term structure of interest ratesPart 3 – Financial Institutions08 An economic analysis of financial structure09 Financial crises in advanced economies10 Financial crises in emerging economies11 Banking and management of financial institutionsPart 4 – Central banking and monetary policy14 Central banks: a global perspective15 The money supply process16 Tools of monetary policy17 The conduct of monetary policy: strategy and tacticsPart 6 – Monetary theory20 Quantity theory, inflation and demand for money21 The IS curve24 Monetary policy theory25 The role of expectations in Monetary Policy26 Transmission mechanisms of Monetary Policy

Goals24.1 Response of Monetary Policy to shocks24.1.1 Demand Shocks24.1.2 Permanent Supply Shocks24.1.3 Temporary Supply ShocksApplication: Quantitiative (Credit) Easing24.2 Active vs Passive Stabilisation Policy24.2.1 Lags24.3 Causes of Inflationary Policy24.3.1 Cost-Push Inflation24.3.2 Demand-Pull Inflation24.3.3 Raising the Inflation Rate24.4 Inflation Overview24.4.1 Definition and Measurement24.4.2 Impulses vs Spirals24.4.3 Money and Inflation24.4.4 Social conflict and Inflation Proneness24.4.5 Combating Inflation24.4.6 The Cost of InflationExamine the role of monetary policy in creating inflation

and stabilizing the economyAddress the question of whether monetary policy should be activist or passive

Monetary EconomicsParts 1 - 6

Monetary Economics (ECS3701) 24 - Monetary Policy Theory

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Transcript of Monetary Economics (ECS3701) 24 - Monetary Policy Theory