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Transcript
Stabilising the economy: Central Banks and Monetary Policy Topic 4 MSc EPs Hilary term 2011 Professor Dermot McAleese 1 Aim of economic policy is to reduce volatility of market economy GDP without counter-cyclical policy GDP GDP with counter-cyclical policy Potential GDP 2 time PRICE STABILITY AND THE CENTRAL BANK Price stability defined Why is price stability important? Role of Central Bank Monetary policy – objectives and instruments Effectiveness of monetary policy 3 Latin American Inflation, average annual rates 1980-85 1986-90 19912000 2001-04 Chile 21.3 19.3 8.5 3.1 Bolivia 611.0 46.5 12.7 2.1 Mexico 60.8 69.6 15.2 4.7 Argentina 322.5 584.0 9.0 15.0 Brazil 149.0 657.5 434.2 8.7 Peak rate since 1970 505 (1974) 11705 (1985) 132 (1987) 4924 (1989) 2407 (1994) Source: IMF, World Economic Outlook, successive issues; Bank of International Settlements, 64th Annual Report, Basle 2000. 4 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) Sources of measurement bias Composition bias Quality bias Substitution bias Note: Should asset prices be included in CPI? 5 WHAT CAUSES INFLATION? Inflation is always and everywhere a monetary phenomenon (Friedman) Demand shocks (property price boom) Supply shocks (oil, energy price increase) Budget deficit Money supply 6 WHAT CAUSES DEFLATION? Demand shocks (property price fall; stock exchange collapse) Supply shocks (interest rate increase) Budget surplus Money supply – credit reduction 7 ECONOMIC COSTS OF DEFLATION (DMcA pp 284-286) Inefficiency effects Redistributive wealth effects Adverse dynamics – deflationary spiral Costly to restore price stability 8 Fisher’s Paradox The more debtors pay, the more they owe. (the chief secret of most if not all great depressions) 9 JAPAN’S DEFLATION (Box 12.1 pp 290291) Land prices and commercial property fall by 50% 19901995. Commercial estate prices fall 87% in real terms (Koo, 258)* Nikkei index falls from 38,900 in 1989 to under 10,000 (just over 7.000 in March 2009) Consumers prices decline “Adverse dynamics” dominant Combination of debt and deflation ‘a lethal cocktail’. Balance sheet recession ‘Zero interest floor’ problem * Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 200910 Japan's Deflation 1995-2010 2.0 1.0 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 -1.0 -2.0 Source: CPI data, taken from World Bank, OECD 11 TASKS OF CENTRAL BANK Monetary policy Lender of last resort -- preservation of financial system ----------------------------- Exchange rate defence Manage official foreign reserves Government banker 12 THE CENTRAL BANK Price stability – ultimate objective Intermediate targets Money supply Inflation ‘lead’ indicators Exchange rate Employment, economic growth? 13 Objective European Central Bank (ECB) Primary objective of the Eurosystem is to maintain price stability. 14 TASKS of Federal Reserve Bank Objective is “to attain maximum employment, stable prices and moderate long term interest rates”. 15 Euro Area’s Money Supply June 2009 (€bn) • Currency in circulation • Overnight deposits 735 3,505 €4,240 Narrow Money (M1) • Short-term Deposits (Quasi-Money) • Money Supply (M3) Source: ECB Monthly Bulletin M3 at june 2010 is €9,419 bn ECB Sep 2010 5,190 €9,430bn Memo: GDP 2008 = €9,200 bn 16 ACHIEVING PRICE STABILITY Political commitment Institutional framework Independent Central Bank Clear policy objective Fiscal sustainability 17 European Central Bank (ECB) Neither the ECB, nor a national central bank, nor any member of their decisionmaking bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body. 18 POLICY INSTRUMENTS OF CENTRAL BANK Open market operations Interest rate DMcA pp318-333 Minimum reserve ratio ----------------------------------------Intervention in forex markets Direct controls -------------------------------------------Unconventional measures 19 Euro banknotes in circulation December 2007 (€677bn) Banknotes €5 €10 €20 €50 €100 €200 €500 No of notes (m) 1,300 2,000 2,250 4,500 1,200 150 480 Value (€bn) Source: computed from ECB Annual Report 2007 6 20 45 220 120 30 240 20 Central Bank Policy Instruments since 2007 Lending Operations More More counter- liberal parties collateral Outright purchases Longer term Forex Foreign Swaps Exchange Equities Private Gov't debt debt Bail-outs, capital injections √ Australia √ √ √ Britain √ √ √ √ √ √ √ √ possible possible √ √ √ possible possible √ √ √ √ √ √ √ √ √ √ Canada √ Euro area Japan Sweden √ √ Switzerland United States √ √ √ √ possible √ √ √ √ China Source: Economist April 2009; DMcA estimates 21 Key Policy interest rate 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 ECB BoE ECB: main refinancing rate BoE: official bank rate Fed: target rate 01/01/2009 01/01/2008 01/01/2007 01/01/2006 01/01/2005 01/01/2004 01/01/2003 01/01/2002 01/01/2001 01/01/2000 US 22 EEAG report feb 2010 (updated) 23 INTEREST RATES AND ECONOMIC ACTIVITY (pp 315-318) THE MONETARY TRANSMISSION MECHANISM 24 MONETARY POLICY AND REAL GDP 1. Substitution effect (-) i (-) Saving, (+) Consumption 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 (+) Consumption 4. (+) Investment Cost of Capital (Investment) effect (-) i (+) Investment 25 MONETARY POLICY AND REAL GDP 5. Exchange rate effect (-) i depreciation of real exchange rate 6. CB credibility effect (-) i (+) domestic confidence 26 HOW MONETARY POLICY COMBATS DEFLATION Fig 13.6 p 321 Relax monetary policy Higher money base Lower interest rate Growth in private sector credit Asset price boost? More spending More output in short run Consumer price increase Price stability and economic recovery More at work 27 If actual output > potential output, restrictive monetary policy will reduce dangers of inflation Objective is to secure a soft landing …. 28 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? 29 Limitations of monetary policy • Nominal interest rate cannot go below zero (ZIRP) • When prices are falling, real interest rate can stay high even as nominal rate falls • Monetary policy encourages spending but cannot make it happen 30 Questions for Group work 1. Define price stability. Why is attainment of price stability important? 2. What policy actions can a central bank take to prevent deflation? 3. Can the use of monetary policy on its own cure a recession? What are the limits to its effectiveness? 4. Q 3 p. 303 --- does business prefer rising prices to falling prices? 5. What actions if any should the ECB take to reduce the Euro area’s high unemployment rate? 31 You can tell whether a man is clever by his answers. You can tell whether a man is wise by his questions. Naguib Mahfouz Nobel Prize for Literature 1988 32 Exercise 5 p. 332 During 2003-4, as nominal interest rates fell to near zero, there was much discussion of the need for central banks to have recourse to ‘unconventional measures’ in order to stimulate aggregate demand. These measures included: a) b) c) d) e) Direct increases of the monetary base Purchase of corporate debt Purchase of government bonds to reduce long term interest rates Buying private securities to boost asset prices Explicit commitment to higher inflation target of 3 per cent. Analyse how each of these measures might be expected to impact on aggregate demand. CONCLUSIONS Price stability is good for economic growth Deflation is just as damaging as inflation Aggressive monetary policy required to prevent deflationary adverse dynamics taking hold In times of crisis monetary policy not enough on its own. Expansionary fiscal policy also needed 34 G20 COMMUNIQUE LONDON APRIL 2009 Monetary Policy in Action 35 Monetary Policy not enough …. …….. in current conditions monetary policy will be insufficient. This is a Keynesian situation that requires Keynesian remedies. Budget deficits will end up at levels previously considered unimaginable. Martin Wolf Financial Times Wed 22 Oct 2008 36 OECD Economic Outlook Nov 2009 p. 38 37