The Conduct of Monetary Policy and Strategy

Conduct of Monetary Policy Health of the Economy

Overly expansionary High Inflation Reduced Economic Efficiency Lower Growth Levels

Too Tight Serious Recessions Reduced Output Lower Prices

Financial Instability Deflation Rise in unemployment

What Central Bank Should do?

Have a discretionary Monetary Policy More expansionary than people and firms expect

Role of Expectations

Decisions about Reflect about workers and firms’ Higher expectations But not much increase
wages and prices expectations about inflation lead to higher inflation in output on an average
 Not to have an expansionary Monetary Policy?
Discretionary Monetary Policy
Firms & workers raise their expectations about inflation
Becomes more Expansionary
So, better to have long-term perspective and avoid
unexpected expansionary MP

High inflation with no gains in output on an average

Short Run Is inconsistent with Long Run

Boost Output &

Lower Inflation
Unemployment Targeting
Nominal anchor

Such as inflation rate or That ties down price level Price stability Promotes low and stable inflation expectations
MS

Limit Time inconsistency Problem

So, can we have a monetary policy that is discrete? What is meant by discrete.

Can we have a monetary policy that is conducted on a day to day basis?

To keep a nominal anchor such as inflation rate or money supply

Low and stable inflation

By keeping prices in check

Limit the TIME INCONSISTENCY PROBLEM

 WHAT’S WRONG WITH INFLATION?

Inflation Social & Economic Costs

↑ Price Level Complicated decision making

Instability & uncertainty Less efficient financial system

Public is hostile to inflation Can result in conflict

Argentina Zimbabwe Sri Lanka

Brazil Russia
 Price stability Goal becomes one of the most important goals of any monetary policy. What else?

1. High employment and output stability

2. Economic growth
3. Stability of financial markets
4. Interest rate stability
5. Stability in foreign exchange markets

Dual Mandate Hierarchical Mandate

Short Run Long Run

CONFLICT OF GOALS
 1. High Employment and Output Stability

Say, a situation of high unemployment – idle workers – loss of output – fall in GDP

So employment can go how high? Full employment conditions?

No worker out of job or unemployment = 0

Unemployment – frictional (temporary loss or lack of matching jobs)

structural (mismatch between job requirements and skills)

A point where demand for labour = supply of labour

Natural Rate of Unemployment 4-6% can be lowered?

Unemployment > 0

Natural Rate of Output – Potential Output – potential GDP – Maximum Rate of Employment

NAIRU - non accelerating inflation rate of unemployment

 2. Economic Growth

Create a steady growth High Employment

Encourage Training and

people to skills
High Investments save development

Higher productivity Low Unemployment

Tax incentives

What is the role of MP here?

 3. Stability of Financial Markets
If financial crisis – instability of markets – channeling of funds is difficult – less productive activities – sharp
contractions

4. Interest Rate Stability

Fluctuations in int rates – instability and uncertainty – uncertain in demand – changes in int rates –
increase in int rate or reduction in prices – capital losses – changes in long term bonds

5. Stability in Foreign Exchange Markets

Increasing importance of international trade to the economy – countries that are largely dependent on
foreign trade

If the currency ($) rises – market becomes less competitive if it falls, can stimulate inflation in the country

Avoiding large changes in the value of dollar in foreign exchange markets

 Short Run Long Run

There is conflict between goals and price There is no tradeoff between inflation and
stability, the importance of price stability can employment. In long run, thus if price
conflict with the goal of output stability and stability is achieved, it does produce output
growth and promotes stable int rates and fin stability

But to control prices

Economic expansions CB may increase Interest rates

Conflict of Goals
Lower unemployment So, the interest rates are unstable
Dual Mandate

Raise expectations Output falls

Hierarchical Mandate

Raise prices Even output fluctuations are not good

overtime
 Dual Mandate – Price stability + Employment
Hierarchical Mandate – as long as price stability is achieved other goals can be pursued

Reserve Bank of New Zealand

A downside of hierarchical mandate is that it puts too much emphasis
Bank of England
on price stability/ inflation control and not on stabilizing output.
So, keep price stability a long term goal. Allow inflation to deviate from its Bank of Canada

long- run goal for short period of time.

European Central Bank

If output is kept stable, over a period of time - there will be long-term consequences of inflation.
Since price stability is preferred, even in short run - output fluctuations are tolerated.

TIME INCONSISTENCY PROBLEM OF MONETARY POLICY

What type of mandate does the RBI follow?
Keep price stability a long run goal and have a nominal anchor as a good tool to limit the fluctuations in
prices

Monetary targeting

Inflation targeting
India Inflation Targeting
Federal Reserve - “just do it”

- No formal anchor
- Transparent
- Preemptive forward looking policy
- No inflation targeting till 2012 (achieved low
inflation and good growth)
- No accountability
- No predetermined criteria

Ideal Goals

Set a date for inflation targeting

FOMC - should all agree and not deviate

Trying to move towards inflation targeting slowly

 Lessons for Policy Makers on How the Economy Works

1. Development in financial sector has a far greater impact on economic activity than we ever
realised. Financial frictions have important role in fluctuations in business cycles
2. Zero bound on interest rates can be a serious problem. Such a rate can force the central bank to
use unconventional policy tools which are harder to use effectively and have uncertain impacts
3. High cost of clearing up after financial crisis. Higher unemployment caused by deep recessions
higher debts can be difficult and costly to correct.

Using stability mechanisms the Federal Reserve Bank did achieve “Great Moderation”

But still financial stability was not attained .. in fact can we say that it may have promoted it?
How?

Low volatility of inflation and low output fluctuations may also result in ….Crisis?

What these lessons mean for Inflation Targeting?

 Implications for Inflation Targeting

1. Level of the Inflation Target - is inflation target too low if the int rate is zero bound? Kept inf target
at 2% and lower bound int rate is almost zero.

Since, Real int rate = in - exp inf (nominal - expected inflation)

If say only by keeping int rate at 0, you get benefit from a higher inflation target

If say by influencing the nominal interest rate, there is more scope for expansionary policy

However, there are other costs to increase inflation – it is difficult to stabilize inflation at 4%, if 4% then 6% and … 8%

Difficulty of containing at 4%

2. Flexibility of Inflation Targeting - to allow some short run deviations of inflation from the target - so
that - output stability and overall price stability can be achieved
 Advantages of Inflation Targeting

1. Reduction of time inconsistency problem - it is less likely that the CB falls in the time inconsistency
trap of trying to expand output and employment in the short run. Reduce political pressure -
economic growth and employment through monetary policy.
2. Increased Transparency - policy making, communication with governments, information to public,
publish documents. Such reports help reduce uncertainties and improve planning and investment
decisions. Clarify responsibilities.
3. Increased Accountability - predefined and pre-announced targets, well defined targets as we saw in
case of new zealand bank.
4. Consistency with Democratic Principles - since central bank should have complete control over
operational decisions and so can be held accountable for achieving assigned objectives.
5. Improved Performance - inflation targeting has worked well for economies. Reduced inflation rate
and inflation expectations which have stayed low.
 Disadvantages of Inflation Targeting

1. Delayed signaling - at times the target may not immediately signal to the public and market - due to
time lag. So, not easy to control. Inflation as a outcome of monetary policy is revealed after
substantial lag.
2. Too rigid? Maybe not. Since useful policy strategies exist that involve forward looking behaviour -
that means - no undesirable behaviour with long run consequences. Using all information to decide
which policy is appropriate to achieve inflation target - use of discretion - modify if required - leave
considerable scope to achieve inflation target.
3. Potential for higher output fluctuations? No. inflation targeting may not necessarily mean one
target. The reason why they choose a 2 - 2.5% inf target and > 0, is that deflation does not have
negative consequences on economic activity - such deflations can lead to economic contractions -
Bank of Japan - finally targeting at inflation around 2%
4. Low economic growth - once low inflation is achieved, output recovers and it is not harmful to real
economy. Therefore, In addition to controlling inflation, it will promote real economic growth.
 Should Central Banks try to Stop Asset Price Bubble
↑ Increase in Asset prices
So, any policy to control it?
Any policy to break the bubble?
Driven by credit
Easy Credit Easy purchases
Higher value of capital
Further increase in demand Further ↑ prices
Bubbles Burst
● Costly
● Brings down financial systems
● Economic downturn
● Unemployment
● Hardship increases
Driven by Expectations
Increased prices Encourages further lending
Easy to borrow Increase in value of collaterals
Asset prices are rising well
Credit boom
above fundamental values
Irrational exuberance – overly optimistic expectations

Driven by credit –

subprime lending and housing prices

then market crashed and credit reduced – prices fell further – lower spendings – lower incomes

lower economic activity

Overly optimistic expectations –

the tech bubble of 1990 – driven by expectations – milder and less impact on economy

So, whether or why should the central bank correct the bubble?

The debate is not whether the central bank should respond at all, it is how much/ or to what extent
to respond
“Lean vs Clean” debate

Why to not take actions to prick the bubble “Greenspan doctrine”

- Not possible to clearly identify

- Do not expect that tools will be effective even if you use tools, damage is too large
- A blunt policy cannot be used to correct the bubble that has developed in the market
- High costs - slows economy, unemployment
- Demand is not impacted the target asset price to certain extent
- Respond in timely fashion to ease policy post bubble bursts

Why to burst the bubble

- hard and costly to clean up

- Price and output stability can in fact lead upto credit bubbles
- Go against credit driven asset price bubbles
- Not against exuberance driven asset price bubbles
Regulation
What policy can correct credit driven asset price bubbles?

What policy can stem the negative impacts of exuberance driven bubbles?

Any policy can work under a system of an excellent foundation in the form of REGULATION
 Risk taking channel of Monetary Policy

Regulatory Policy Well built MP Effective

Supervision
All regulatory policies

Well Functioning ● Check on excessive risk taking *

Well Built ● Capital requirements

Countercyclical

Macroprudential
2 1
regulator
Adjust upward Adjust downward

BOOM BUST
● Compliance requirements
● High credit standards

* overly easy Monetary Policy, promotes instability, lower interest rate leads to excessive risk taking
 Tactics: Choosing the Policy Instrument

● OMO
● RR
Easy? OR ● DR
● IOR
Tight? ● LSAPS
Policy Instrument ● FG

Reserve aggregates Interest rates

● Total reserves ● FFR

● Non-borrowed reserves ● Short-term Interest
● Monetary base rates
● Non-borrowed base

Intermediate target
Tools Goals
Say, nominal GDP growth rate of 5% (Goal) – can be achieved by a 4% growth rate for M2 (intermediate target) – which
will in turn be achieved by a 3% growth rate of NBR (policy instrument) – set the FFR (a policy instrument) at 4%

A central bank can choose to target both the NBR and the FFR policy instrument at the same time? NO.

Let’s try it out ….

Criteria for choosing the Policy Instrument

1. Observability and Measurability

2. Controllability
3. Predictable Effect on Goals

Taylor Rule – John Taylor: the monetary authority should raise nominal interest rate by more than
increase in the inflation rate – Taylor principle

(If the rise in nominal int rate is less than the inflation rate, the real int rate falls when inflation rises)

FFR target = Inflation rate + eqm Real fed funds rate

+ ½ (inf. gap) + ½ (output gap)

Current inflation an indicator of future

- target rate inflation

%deviation of real GDP

from potential (natural
rate) level
say, an eqm FFRr of 2%

target for inflation of 2% , suppose the inflation rate is 3% – positive inflation gap of 1%

the real GDP is 1% above potential – positive output gap of 1%

Then the FFR should be targeted at …

https://www.cmegroup.com/openmarkets/economics/2022/Assessing-Monetary-Policy-Through-The-Taylo
r-Rule.html