Things to consider in monetary policy

implementation
• Lucas critique
• Time inconsistency
• Rules vs discretion
• Credibility
Monetary policy and asset price
• Types of asset bubbles
• The choices in tackling asset bubbles.
• Global liquidity
One more monetary regime
 Taylor’s Rule
• Along with inflation targeting, many central banks have
adopted the use of setting a target for short term interest
rates. How is the target chosen?
• Taylor’s rule: r   t  r * 0.5 * 0.5 *
where, r=nominal interest rate; t : inflation rate; r*:
equilibrium real CB rate; *: inflation gap (t-T); *: output gap
(t-T). Superscript T indicates targeted value.

• The presence of output gap in Taylor’s rule indicates that the

CB should not care only about keeping inflation under control
but also to minimize business cycle fluctuations of output
around its potential level – this is consistent with Fed’s dual
mandate.
 Taylor’s Rule
• Alternative reason why we examine output gap is:
The output gap can be an indicator of future inflation.
Inflation usually occurs with lags after an increase in output.
The wide the gap between the actual and targeted output,
the higher the pressure on the inflation.

• Additional note: employment can be an indicator of future

inflation too. According to nonaccelerating inflation rate of
unemployment (NAIRU) theory, if actual unemployment is
above NAIRU (output is below its potential level), price will
drop and vice versa.

(See the attachment in the edmodo about the measurement of

output gap and potential output in Malaysia)
Things to consider in monetary policy
implementation
 Lucas critique
• Some basic reviews:
• Adaptive expectation-past info, slow adjustment
• Rational expectation-___________________
• Hybrid expectation
• Lucas critique: Any changes in policymakers behaviour
will change the expectation of the people. Subsequently,
the reactions of the people will change accordingly and
causing alteration in the relationships between
economic variables.

• Rational expectation plays important role in the Lucas critique.

Do you agree with the rational expectation?
• Implications:
1.
2.
 Lucas critique
• Example 1: Government would like to reduce the interest
rate to encourage investments. However, this could imply
higher inflation rates in the future, and economic agents
could quickly form this expectation. Eventually, this prompts
people to demand for higher wages. Subsequently, the firms
will reduce the investments due to higher cost.

• Example 2: We test the impacts of an economic crisis to

private consumption. We managed to measure the impact
from an econometrics equation. However, consumption
pattern could change following a crisis such as consumers
can be more prudent in spending. Therefore, we cannot use
the same conclusion to predict the consumption impact in the
next economic crisis.
 Time inconsistency
• Refers to the situation when policy makers has the incentive
to promise a certain action in the future but when the time
comes do not do as promised. At the same time, other
economic agents will also expect that the agent will not
behave as promised.
• Has been discussed widely as an issue that arises in the
conduct of monetary policy and politicians.
• How does it happens?
1. The central bank cares about inflation and unemployment.
2. However, there is a tradeoff between inflation and
unemployment.
3. The central bank would prefer economic agents to expect
low inflation so that there is a favourable trade off.
4. To create the low inflation expectation, the central bank may
____________________________________________.
 Time inconsistency
5. Upon the announcement, economic agents will form their
inflation expectations accordingly. When this happens, CB
has the incentive to renege on the announcement and
implement expansionary monetary policy to reduce
unemployment.
6. However, __________________________, they will soon
learn that there is incentive for CB to renege and therefore
may not believe the announcement in the first place.
7. As a result, economic agents may raise their expectations
on inflation, driving wages and prices up. The rise in
wages and prices will lead to higher inflation but will not
result in higher output on average.
• Hence, there is the argument against discretionary
monetary policy and there is advocacy for a ruled or
committed policy.
Further Reading: Mankiw’s commentary on time
inconsistency
http://gregmankiw.blogspot.com/2006/04/time-
inconsistency.html
 Rules vs discretion
Rules
• A rule based monetary policy –
________________________________
• A rule involves the exercise of control over the monetary
authority’s in a way that restricts the monetary authority’s
actions.
• Example of monetary policy rules:
• Constant money growth rate rule (monetarists)
• _____________________________________________
_____________
• Subject to revision but more predictable because the
revisions are infrequent compared to the change in
decisions and expectations of firm (household).
 Rules vs discretion
Case for Rules
• A commitment to a rule solves or reduces the time
inconsistency problem and limits the policy makers from
exploiting short run tradeoff between inflation and
employment and enable policy makers to achieve desirable
long run outcome
• Policy makers and authorities cannot be trusted (Friedman
and Schwartz,1963). Politicians who make fiscal policy
have strong incentives to pursue policies that help them win
the next election and this may be detrimental to the
economy and leads to political business cycle.
 Rules vs discretion
Discretion
• A monetary authority is free to act in accordance with its
own judgment.
• They make no commitment to future actions, but instead
make what they believe in that moment to be the right policy
decisions for the situation.
• Time inconsistency problem reveals the limitations of
discretionary policy

Further reading: Dwyer, G. (1993), Rules and discretion

in monetary policy. Federal Reserve Bulletin, Vol.75 (3),
pp3-14.
 Rules vs discretion
Case for Discretion
• Rules can be too rigid because it cannot foresee every
contingency
• The rule based decision making do not easily incorporate
the use of judgment. Monetary policy is as much an art as
a science. Authorities need to consider a variety of
information to make decisions and some of this information
are not easily quantifiable and made into rule.
• Rules that are based on a certain model may not be
applicable when the model of the economy changes.
Discretionary policy allows flexibility.
• Even if the model is correct, structural changes in the
economy could lead to changes in the coefficients of the
model and thus, affect the effectiveness of the rules.
 Credibility of monetary policy
• Credibility of monetary authorities/monetary policy play an
important role in the effectiveness of a policy decision.
• It relates to the commitment for nominal anchor (inflation,
money supply or exchange rate). Numerical target on the
nominal anchor is assigned.
• Being committed to the nominal anchor allows:
1. Discretionary policy to be more consistent with nominal
anchor
2. _______________________________________________
___________________.
• Examine the importance of credibility in the short run
following:
• positive aggregate demand shock
• negative aggregate demand shock
• aggregate supply shock
• anti-inflation policy
 Credibility & Positive AD shock
• Firms gets positive news and
LRAS increase their (I).
• Hence, AD increases to AD2.
Eqm moves from point 1 to
AS1 point 2, inflation rises about
target (π2).
• Stabilization policy (tightening
π2 2 of MP) will take some time for
πT AD to shift back to AD1.
1
AD2 Credible policy:
• Public’s expected inflation πe
remains unchanged and AS
AD1 remains at AS1.
• Inflation will not go beyond π2
and over time, AD will shift
Y* Y2
back to AD1 and inflation falls
back to πT.
 Credibility & Positive AD shock
Policy not credible:
LRAS
• Public worry
______________________
AS3 ______________________
_____________
AS1
3 • Weak credibility will cause
π3 expected inflation πe to rise
π2 2 and AS to shift to AS3 and
πT eqm achieved at point 3 in
1 short run. Inflation rise
AD2
further to π3.
• If authorities tighten MP and
AD1 return AD to AD1, inflation
has risen more than it would
be if authorities have
Y* Y1 Y2
credibility.
 Credibility & Negative AD shock
• Consumer confidence dips.
• AD shifts to the left (AD2) and
LRAS economy moves to point 2
and output falls to Y1 and
inflation fall below target
AS1 (π2).
• Stabilization policy would
πT
involve easing of MP which
1
will moves AD back to AD1.
π2 2 Credible policy:
AD1 • Public’s expected inflation πe
remains unchanged and AS
AD2 remains at AS1.
• Economy will gradually
Y1 Y* return back to point 1.
 Credibility & Negative AD shock
LRAS Policy not credible:
• Public may interpret
AS3 ______________________
______________________
AS1
______________________
• Inflation expectation may
πT 1 increase and so AS shifts to
3
π3 AS3. Economy goes to
π2 2 point 3.
• Result in greater contraction
AD1
in output in the short run.
AD2

Y2 Y1 Y* Monetary credibility important in stabilizing

economic activity when there is a AD shock.
 Credibility & AS shocks
• Suppose energy prices
increase (inflation shock)–
LRAS
AS shifts to the left.
AS3 • The shifts of AS curve
AS2 depends on the credibility of
AS1 the policy to keep inflation
π3 3 Credible policy
2 • unchanged.
AS will shift slightly to AS
π2 2
1 and economy moves to point
πT
2. Inflation rises slightly to π2
and output falls slightly to Y1.
AD1 Not Credible policy
• AS will shift to AS3 and
economy moves to point 3.
Inflation rises more to π3 and
Y2 Y1 Y*
output falls more to Y2.
Applications: Tale of three oil shocks
 Credibility & anti-inflationary policy
• Suppose there is high
LRAS inflation of 10% at π1 &
economy at point 1.
AS1 • CB wants to reduce inflation
1 to π4 =2%. We do tight MP.
Π1 • This shifts AD to AD4.
AS3

Perfectly Credible policy:

Π4 4 • If CB is perfectly credible,
AD1 public will lower inflation
expectation accordingly and
AS shifts to AS3.
AD4 • Economy moves to point 4
and inflation is lowered
Y*
without the loss of output.
 Credibility & anti-inflationary policy
High credibility policy:
LRAS
• If CB has high credibility and
public believes the CB,
AS1 expectations of inflation will
AS2
fall and AS curve will shift
1 down to AS2.
Π1
AS3 • Economy moves to point 3
2
Π2 and output decline to Y1.
3 inflation will fall to π3.
Π3
Π4 4
Non credible policy:
• Public is not convinced and
hence may not revise their
AD4 expectations and hence
economy moves to point 2 and
Y2 Y1 Y* output decline to Y2. Inflation
drop to π2.
Monetary policy and asset price
 Monetary policy and asset price
• One of the economic phenomena that has happened
frequently over the last few decades is the asset price
bubble, a situation where asset prices appreciate in large
magnitude and deviate from it fundamental value.

• Types of asset price bubble:

1. ____________________________
- Starting from cheap credits that inflate demand for assets.
Eventually, prices up and results in higher collateral values
are available for further borrowings.
- When bubble burst, the reverse will happen. Bad loans
incur, bank reduces lending, demand for asset drops,
greater reduction in asset price, lower collateral values…….
 Monetary policy and asset price
2. _________________________
-For example, technology, oil price and palm oil industry
experience boom periods during certain times over the last 20-
30 years. It is more to sector impacts and the banking sector
will not be heavily hit by the burst of bubble.

• Since asset prices are crucial in monetary transmission

mechanism, the relevant issues now is should we go for
_____________the bubbles or __________ after the burst.
• Why we should go for leaning against the bubbles:
1. Prevent the credit-driven asset bubbles.
2. The credit booms can be roughly identified when the asset
prices and credit supply increase rapidly at the same time.
 Monetary policy and asset price
• Why we should go for cleaning-up burst:
“Greenspan doctrine” proposes that CB shouldn’t try to stop
bubbles. Why?
1. Not easy to detect the asset-price bubbles by government and
the public. There is no fixed definition too.
2. Interest rate that used to prick the bubbles could be ineffective
because higher interest rate can promote higher returns for
bubble-driven assets.
3. Bubbles could due to irrational market behavior and that need
unconventional tools to prevent negative effects of bubbles.
4. Bubbles can happen in specific assets or industries. A general
monetary policy might not able to tackle these bubbles.
5. Easing monetary policy after the burst could be effective to
recover economy.
 Monetary policy and asset price
• What can be done to constrain the bubbles?

1. Macroprudential regulation/policies.
 control the credit creation of financial institutions.
 Capital adequacy ratio (time-varying and fixed), loan to
valuation ratio, contingent capital requirement (debts that can
be converted into equity),, requirement of higher quality capital.
Explicit limits on credit growth, varying reserve requirement,
dynamic provisioning.
2. Monetary policy
 ______________________________________
 Monetary policy and asset price
• The criticism about the macroprudential
regulation/policies
1. Subject to political pressure from financial institutions
because they will be directly affected by these policies.
2. Financial institutions could cheat.
3. It cannot prevent the occurrence of a new financial crisis
because it doesn’t overcome the cause of financial crisis.
The causes is financial institution has the tendency to
take risky decision.
4. Three issues are still debated:
a) What are the functions of macroprudential policies and
how to measure the progress.
b) What tools to achieve the objectives.
c) Who should control and account for the outcomes.
 Global liquidity
• What is global liquidity?
Can be considered as foreign money supply. The foreign
money supply can spread to other countries due to:
1) _____________________________________.
2) ______________: oversupply of liquidity push the liquidity
to flow to other countries for higher returns.
3) ______________: better economic outlook for global
liquidity recipient countries.
 Global liquidity
• The impacts of global liquidity on recipient countries:
1. Currency appreciation.
2. Higher general price level/asset price.
3. The domestic liquidity condition will be influenced, leading
to higher difficulty to conduct monetary policy (monetary
policy autonomy will be undermined).
4. Leading to co-movement in domestic and foreign
monetary aggregate.

* Note: the occurrence of global liquidity also links to

________________________l.