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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

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

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

01/0

1/20

10

01/0

1/20

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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