Monetary Policy and Inflation

Chapter 29 & 30

Monetary Policy

Channel of Monetary Policy

• When the central bank increases the monetary base, the money supply will increase.

• Banks have excess liquidity which they use to make more loans.

• The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate.

Dynamics of Monetary Transmission

• Money supply expansion reduces interest rates

• Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods.

• Lower interest rates increase demand for US$ in forex market depreciating the exchange rate.

• Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

Monetary Transmission Mechanism

ECB Web Site

Monetary Policy: Money Supply Expands

i

Money Demand

i*

Money Supply

M

Money

Supply’

i**

1

2

P

YAD

Expansionary Monetary Policy

AD′

ΔI ΔC, ΔNX

P

Y

AD

An Expansionary Cycle Driven by monetary policy

P*

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

2. Monetary Policy Cuts Interest Rate

3. Investment rises. The AD curve shifts out.

4. Tight labor markets. SRAS returns to long run equilibrium

3

Monetary Policy – Short-term vs. Long Term

• In the short-run, expansionary monetary policy can boost economic growth.

• But in the long-run, expansionary monetary policy only leads to rising prices (i.e. inflation).

Interest Rate Management

• In most economies around the world, the central bank does not simply act to maintain a fixed money supply.

• Rather, they adjust money supply to maintain and manage interest rate changes in response to business cycle conditions.

Monetary Policy

• In the US (and Euroland and Japan and most OECD economies), the central bank sets monetary policy by picking a short-run interest rate they would like to prevail.

• In HK, the central bank sets monetary policy by picking a fixed exchange rate.

U.S. Central bank cuts interest rates during recessions

P

Y

AD

Demand Driven Recession w/ Counter-cyclical

monetary policy

P*

SRASYP

AD′1

2

Gap < 0

3

1. Economy in a recession. Fed detects deflationary pressure

2. Monetary Policy Cuts Interest Rate

3. Investment increases spending to shift the AD curve back to long run equilibrium

P

Y

AD

Demand Driven Expansion w/ Counter-cyclical

monetary policy

P*

SRASYP

AD′1

2

Gap > 0

1. Economy in expansion. Fed detects inflationary pressure

2. Monetary Policy Raises Interest Rate

3. Investment decreases spending to shift the AD curve back to long run equilibrium

3

Price Stability

• Counter-cyclical monetary policy stabilizes output near potential output, YP, but also stabilizes the price level near P*.

• Central banks may pursue price stability as a goal and also stabilize output as well if business cycles are caused by demand shocks.

Policy FrameworkPrice Stability

• Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “

• ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

• Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

The Great Moderation

•The Great Moderation by Federal Reserve Bank of Dallas

Taylor Rule• Economist named John Taylor argues

that US target interest rate is well represented by a function of

1. current inflation

2. Inflation GAP: current inflation vs. target inflation

3. Output Gap: % deviation of GDP from long run path

• Function: Inflation Target π* = .02*1 1

2 2.025 ( )TGTt t t ti Output Gap

The Taylor Rule Download

What should be the current Fed Funds rate? Will they be increasing

it soon?• Step 1. Find Inflation Rate

• Step 2. Find Output Gap

• Step 3. Calculate Taylor Rule implied rate and compare with current rate.

Answer

P_2008_2 121.91P_2007_2 120.00Inflation 0.016Y 11740.3YP 11904.0Output Gap -0.014Inflation Gap -0.004Taylor Rule 0.032Fed Funds Rate 0.02

P

Y

AD

Stagflation w/ Counter-cyclical monetary policy

P*

SRASYP

AD′

1. Economy experiences stagflation

2. Monetary Policy Cuts Interest Rate

3. Investment increases spending to shift the AD curve to long run equilibrium with higher prices.

1

2

3

P**

P

Y

AD

Stagflation w/ Price Stabiliztion

P*

SRASYP

AD′

1. Economy experiences stagflation

2. Monetary Policy Raises Interest Rate

3. Investment decreases spending to shift the AD curve to equilibrium with lower output.

1

2

3

Monetary Policy and Supply Shocks

• In the face of demand shocks, no trade-off between price and output stability.

• In the face of supply shocks, such a trade-off exists.

Question: Problem with Central Bank Stabilization

• Situation: Economy is in long-run equilibrium, but central bank overestimates potential output.

• Draw outcome if central bank believes that the potential output is higher than it is.

P

Y

AD

A Bias toward Expansionary monetary policy

P*

SRAS

YP

AD′

YPhantom

1. Central Bank repeatedly expands the money supply

2. Inflation recurs

SRAS′

4

5

1

2

3

Monetary Policy Lags

• Counter-cyclical fiscal policy beset by lags between the time a recession is recognized and the time the government can form consensus to act.

• Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates.

Inflation

Quantity Theory

• Simplest monetary theory is the Quantity Theory of Money.– Purchasing power of money is equal to the

quantity of money (Mt) times the speed of circulation (V, # of transactions)

– Purchasing power means # of goods (Yt) multiplied by price per good (Pt)

Moneyt * Velocity = Pt * Yt

Rule of Thumb

• Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Z X Yt t t t t tZ X Y g g g

1

1

Z t tt

t

Z Zg

Z

Money and Inflation

• Assuming stable velocity

• Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

M Y Pt t t t tg g g

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18

Average Money Growth

Ave

rag

e In

flat

ion

Rat

e

Ex Ante Rate and the Fisher Effect• Savings and investment decisions must be

made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

• Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

1EA FORECAST

t t ti r

Great Inflation of the 1970’sUS Inflation Rates & Interest Rates

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00M

ar-5

5

Mar

-58

Mar

-61

Mar

-64

Mar

-67

Mar

-70

Mar

-73

Mar

-76

Mar

-79

Mar

-82

Mar

-85

Mar

-88

Mar

-91

Mar

-94

Mar

-97

Mar

-00

Mar

-03

%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Great Inflation Download

Fisher Effect: OECD Economies Great Inflation of 1970’s

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18

Average Inflation 1970-1984

Inte

rest

Rat

es-1

984

Loanable Funds MarketFisher Effect

S

I

LF

r*

LF*

1Et

1Et

i*

Ex Ante vs. Ex post

• We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation.

• The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return.

1ExP ACTUAL

t t tr i

1 1ExP ExA FORECAST ACTUAL

t t t tr r

Unexpected Inflation Winners and Losers

– Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers.

– Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are winners/borrowers are losers.

Inflation Risk

• When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers.

• High inflation rates tend to be associated with unpredictable inflation.

Costs of Anticipated Inflation

• Shoe Leather Costs – Money is a technology for engaging in transactions. The greater is inflation, the greater the cost for individuals of holding money. Individuals must make efforts as a substitute for the convenience of holding money.

• Menu Costs – Firms must engage in costs of changing posted prices. More generally, when prices change rapidly over time, more time and effort must be put into calculating relative prices.

The Inflation Tax

• Banknotes do not pay interest. • The real interest rate on banknotes is

• If inflation is high, currency has sharply negative returns. People will avoid holding money leading to society losing the convenience of money transactions.

1CASH

t tr

•Zimbabwe Inflation Download

Causes of Extremely Rapid Inflation

• Government generates revenues by printing new money (referred to as seignorage).

• Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money.

• Explain the link between deficits and inflation.

Israel 1970-1990

Inflation

0

50

100

150

200

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350

400

1970

1971

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1979

1980

1981

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Israel 1970-1990Surplus (% of GDP)

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

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1990

P

Y

AD

A Bias toward Expansionary monetary policy

P*

SRAS

YP

AD′1

2

Inflationary Gap

1. Central Bank repeatedly expands the money supply

2. Inflation recurs

3. After a time, as inflation becomes expected it will cease to impact output even in the short run.

3

SRAS′

45

Features of Inflation TargetingA medium term communication strategy

• Commitment to price stability as goal of monetary policy.

• Clear statement of numerical target for inflation over the medium (1-2 year) term.

• Communication with public about current forecasts of inflation and policy actions used to achieve target.

• Central Bankers accountable for achieving goals.

Yield Curve

• The yield curve is the gap between the interest rate on long-term bonds and short-term bonds.

• When long-term interest rates are high relative to the short-term interest rates, the yield curve is steep.

• When short-term interest rates are relatively high, the yield curve is flat or inverted.

Monetary Policy and the Yield Curve

• Central bank expands the money supply and short-term interest rate will fall.

• Negative effect on long term real interest rate but…

• Also likely to increase inflationary expectations raising nominal long-term interest rates.

• Yield Curve steepens when money supply expands and flattens when money supply contracts.

•Yield Curve Download

US Yield CurveSeptember 2007: Expansionary

Monetary Policy

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

9/4/

2007

9/6/

2007

9/8/

2007

9/10

/200

7

9/12

/200

7

9/14

/200

7

9/16

/200

7

9/18

/200

7

9/20

/200

7

9/22

/200

7

9/24

/200

7

9/26

/200

7

9/28

/200

7

%

3 month

10 Year

Yield Curve

Learning Outcome

• Calculate the impact of inflation on long-term nominal interest rates using the theory of the Fisher effect.

• Calculate real return on debt as a function of inflation and expected inflation.

• Calculate real return on money as a function of inflation.