Download Chapter 59: The role of monetary policy (2.5)

Chapter 59: The role of monetary policy (2.5)
Key concepts
• Interest rates and aggregate demand
o Expansionary (loose) and contractionary (tight) monetary policy
• Inflation targeting
• Evaluation of monetary policy
o Independence of the central bank
o Time lags
o Keynesian model
o Limits of monetary policy
Liquidity trap
Deep recession
o Policy trade-offs
Monetary policy
and short-term
demand
management
•
Explain how changes in interest rates can influence the level of aggregate
demand in an economy
•
Describe the mechanism through which easy (expansionary) monetary
policy can help an economy close a deflationary (recessionary) gap
•
Construct a diagram to show the potential effects of easy
(expansionary) monetary policy, outlining the importance of the shape
of the aggregate supply curve
•
Describe the mechanism through which tight (contractionary)
monetary policy can help an economy close an inflationary gap
•
Construct a diagram to show the potential effects of tight
(contractionary) monetary policy, outlining the importance of the
shape of the aggregate supply curve
Monetary policy
and inflation
targeting
•
Explain that central banks of certain countries, rather than focusing on
the maintenance of both full employment and a low rate of inflation,
are guided in their monetary policy by the objective to achieve an
explicit or implicit inflation rate target
Evaluation of
monetary policy
•
Evaluate the effectiveness of monetary policy through consideration of
factors, including the independence of the central bank, the ability to
adjust interest rates incrementally, the ability to implement changes in
interest rates relatively quickly, time lags, limited effectiveness in
increasing aggregate demand if the economy is in deep recession and
conflict among government economic objectives
If you would know the value of money, go and try to borrow some. Benjamin Franklin
•
Interest rates and aggregate demand
If you lend someone $100 and get it back in a year, has it cost you anything? “Inflation would mean that the real value of
the $100 is less” you might reply. OK, but what if we assume that inflation during the year was zero? Of course you
would still incur a cost; the opportunity cost of not having access to the $100. You make up for this opportunity cost by
charging interest.1
(Type 5 Smallest heading) Real interest
Assuming that your next-best option is estimated at a money value of $5, then you would charge and interest rate of (at
least) 5% ($100 × 5% = $5). If we now assume that there indeed is a steady rate of inflation, say 5%, what would you do?
Correct; you would charge a higher rate of interest, 10.25%2, since receiving $105 in a year’s time when the price level
has gone from 100 (indexed at the time of the loan) to 105 means that the $105 you get back is worth only $100 in real
terms.
Definition: real interest rate
If nominal interest is eaten up by inflation then there has been an opportunity loss for the
lender. It is therefore more relevant, once again, to focus on real values rather than nominal.
The real interest rate is the nominal rate minus inflation; rreal = rnominal – inflation.
The above illustrates a causal flow from inflation to interest rates; when inflation rises, commercial banks will raise
interest rates to keep a given rate of real interest. However, when the central bank uses monetary policy to increase
interest rates (tight monetary policy), the result is higher costs for borrowing and higher opportunity costs (foregone
interest) of consumption. Higher interest therefore lowers consumption and investment and hence decreases aggregate
demand.
When inflationary pressure rises, the central bank can implement loose monetary policy by lowering interest rates or
decreasing the supply of money (which increases interest rates). Investment becomes cheaper for firms and households
can increase their borrowing for consumption goods – aggregate demand increases. There is also the issue of lower
opportunity costs of consumption since savings do not generate the same interest as earlier – this too incentivises
increased consumption.
**************** OUTSIDE THE BOX***************
The relationship between interest and investment
While it is not directly part of the syllabus, a most useful theoretical concept in understanding underlying forces
connecting interest rates with aggregate demand (and also aggregate supply as shall be seen) is the downward sloping
demand for investment, called the investment schedule (= demand curve for investment). Lower interest rates induce
firms to increase investment for two reasons.
1. Opportunity cost issue: When the interest rate falls, a number of investment opportunities previously considered
unprofitable are suddenly profitable. For example, assume that firms in an economy have only two options for
their retained profit (= profit held over from previous years); put it in the bank or invest it in the firm. Now, say
that firms in an economy itemize and assess all possible investment opportunities and that the current market
interest rate is 7%; any investment which does not yield a rate of return of 7% or more will be put in the bank,
since an investment yielding, say, 6.5% will render the firm an opportunity cost (loss) of 0.5%. Figure 59.1
shows how total investment demand during the year is €10 billion at an interest rate of 7%.
1
During an ‘Open House Day’ at school, I gave a lecture on economics to the parents of my people. I brought up the issue of
opportunity cost and interest. The next day one of my students, Jakob, came back with a bottle of Polish vodka (Zubrowka,
my favourite) as a thank-you gift from his mother. He wasn’t too pleased about things; “Thanks a lot Matt. My mom’s now
charging me interest on money she lent me to buy a computer.”
2
Since you want to have $105 in real terms, you must charge an interest rate that gives you $110.25, i.e. 10.25%.
Say that the economy slows down and the Central bank loosens monetary policy and interest rates fall (as outlined earlier)
from 7% to 6%. Investment options that were previously considered unprofitable suddenly become more attractive; what
firm would leave money in the bank at 6.5% interest when an investment opportunity yields 6.9% - or even 6.55%?!
Firms will therefore increase investment when the opportunity cost of investment (interest being the alternative) falls.
Figure 59.1 Interest rates and quantity of investment (investment schedule)
Investment schedule
r (%)
A decrease in the interest
rate (r) increases the
quantity of investment (QI)
7
6
I
10
2.
12 QI (€billions/year)
Cost of investment: Not all investment is funded internally, i.e. by held-over profits accumulated within the firm.
A great deal of the funding for investment comes from banks and other financial institutions in the form of loans.
When the interest rate falls, the cost of servicing debt (paying interest on loans) goes down and firms will be
willing to take on more debt in order to invest.
The lower rate of interest in this example causes total investment in the economy to increase from €10 billion per year to
€12 billion per year. The inverse relationship between interest and quantity of investment is thus a downward sloping
curve, the investment schedule.
******************END OF OUTSIDE THE BOX*****************************
o Expansionary (loose) and contractionary (tight) monetary policy
When unemployment rises, growth falters and/or inflation shows signs of falling below the floor of a targeted interest
corridor due to decreasing aggregate demand, the central bank can implement loose monetary policy3 to stimulate the
economy. The central bank decreases the discount rate from 3% to, say, 2.5%. Commercial banks now have cheaper
credit on money borrowed from the central bank, and will compete with each other by lowering the lending rates for firms
and households. If commercial bank rates fall to 6.5% there will be a lower opportunity cost associated with investment
and consumption – so savings will fall and investment and consumption will rise. This causes the fall in aggregate
demand to decelerate (the ‘hook’ between AD* to AD1), shown in diagram 59.2.
3
Many of my non-native English speakers struggle with the words “loose” (= slack, movable) and “lose” (= drop,
misplace) – all too frequently mixing them up. One of my colleagues at the Oxford Study Courses has experienced the
same thing and came up with “I keep loose change in my pocket so I don’t lose it.”
Figure 59.2 Demand management using interest rates/supply of money
III: Affect on aggregate demand
Price level
(index)
Increased interest rates will cause
AD to decelerate and have a
dampening effect on inflation. The
inflationary gap lessens.
LRAS
SRAS
P*
P2
P0
P1
AD**
Lower interest rates will have a
stimulating effect, decelerating a
decrease in AD. The inflationary
gap lessens.
AD2
P*
AD1
*
AD
Y1 Y1
AD1
YNRU Y1
Y1
GDPreal/t
Now, say that the economy shows signs of overheating, i.e. that the rate of inflation exceeds a predetermined ceiling rate
of inflation set by the central bank. The central bank, implementing tight monetary policy, raises the discount rate to
3.5% whereby commercial banks immediately respond by raising their lending rates to households and firms – since the
commercial banks will now pay a higher ‘price’ for borrowing from the central bank. The deposit rate will also increase,
since banks will be competing for households’ and firms’ deposits. Assume that the commercial banks increase the
lending rate to 7.5% and the deposit rate to 2.5% - this will increase the opportunity cost of borrowing for
consumption/investment and therefore increased savings and decreased consumption/investment. Taken together, lower
levels of investment and consumption will decrease aggregate demand, or, to be more correct, decrease the rate of
increase in aggregate demand, as illustrated in the ‘hook’ between AD** and AD2 in figure 59.2.4
Note how the effect of an increase or decrease in interest rates is illustrated in figure 59.2 as an ‘increase/decrease in the
rate of decrease’ in aggregate demand rather than using a single aggregate demand curve that shifts to the right or left.
This is not by accident. The reasoning is that monetary policy is often very ‘forward looking’ and seeks to countermand
inflation that has not set in yet. Central banks attempt to steer the economy – or rather, inflation – by looking forward in
time and estimating what inflation will look like – for example by using the PPI to gauge coming inflationary pressure
(see Chapter 52). Interest rates are in effect used to countermand excessive changes in aggregate demand before they
happen. This is because there are significant time lags in operation; it takes between two and six quarters before interest
rates actually affect inflation and up to two years before the full effects on aggregate demand hit. This is why so much
effort is put into predicting future output fluctuations in business cycles.
Another method of loosening monetary policy is by increasing the supply of money as explained in Chapter 58. This is
illustrated in figure 59.3 I-III following the same line of reasoning as above.
4
•
Increased money supply (Sm0 to Sm1) puts downward pressure on interest rates (r0 to r1) and stimulates
consumption and investment expenditure in the economy – note the use of the investment schedule – aggregate
demand is stimulated from AD* to AD1
•
A decrease in the supply of money (Sm0 to Sm2) causes interest rates to rise (r0 to r2) and causes aggregate
demand to contract from AD** to AD2.
An additional effect is that when interest rises it might trigger an increase in demand for the Home Currency – which
thus appreciates the Home Currency causing dearer exports and cheaper imports. Falling export revenue and rising import
expenditure will act in the same direction as in falling consumption and investment; decreasing aggregate demand.
Figure 59.3 Supply and demand for money linked to aggregate demand
II: The investment
schedule
I: Supply and demand for
money
III: Affect on aggregate demand
Price level
(index)
Interest rate
(%/year)
Interest rate
(%/year)
Sm2 Sm0 Sm1
LRAS
SRAS
P*
P2
P0
P1
r2
r0
AD**
AD2
P*
r1
Dm
Q 2 Q0 Q1
Quantity of money ($bn/year)
AD1
AD
I
I2 I0 I1
Investment ($bn/year)
Y1 Y1
*
AD1
YNRU Y1
Y1
GDPreal/t
Increased supply of money..........lowers the rate of interest..........which stimulates C and I in AD.
Decreased supply of money..........raises the rate of interest..........which decreases C and I in AD.
Cut in from Chapter 57:
********* End cut **************
•
Inflation targeting
‘Goodhart was an optimist – just like Murphy!’ Author’s comment on Goodhart’s law5
Increasingly during the latter part of the 1900s, central banks gained increasing independence from
governments in order to increase the predictability of central bank policies and also – if one is to be a tad
cynical – to limit the meddling of politicians using loose monetary policy to fan the flames of their re-election.
The idea is that when a central bank has a publicly displayed inflation target of, say, 2% then stakeholders such
as firms and consumers can readily anticipate central bank policy moves since the measure of inflation (CPI in
most cases) is publicly available on a day-to-day basis. If the central bank ‘keeps its word’ over a period of
time, then households and firms can plan ahead in anticipation of higher or lower interest rates and this should
even-out cyclical swings in the economy. This in turn should allow a steadier rate of growth and even induce
greater investment as inflation rates become more predictable.6
5
Goodhart’s Law states that any time there is an observed regularity – e.g. pattern – in statistical data and one tries to use
the correlation for a given purpose, the observed pattern breaks down. Murphy’s Law states that if something can go
wrong, it will. I think this quote is from the end of my fifth marriage.
6
See a very accessible study by NBER at http://www.nber.org/papers/w16654.pdf
Figure 59.4 Inflation and growth in inflation-targeting countries
(Rory, best disguise this a tad.)
Source: “Inflation Targeting turns 20”, Scott Roger, IMF, at
http://www.imf.org/external/pubs/ft/fandd/2010/03/pdf/roger.pdf)
Some 26 countries in the world apply inflation targets with set inflation target rates of around 2 to 3%
inflation. For example, one of the first countries to adopt an inflation target was Sweden in 19937, where
Svenska Riksbanken (the central bank) has had a target of 2% inflation per year with a +/- tolerance of a
percentage point – e.g. inflation is allowed to fluctuate between 1% and 3% without central bank intervention.
There is some evidence that the setting of inflation targets does work to lower long run inflationary trends.
Figure 59.4 illustrates how inflation-targeting (IT) countries generally had lower inflation rates and higher
growth trends than non-IT countries. (It should be mentioned that the US central bank, the Fed, does not have
an inflation target but instead a goal of low inflation and low unemployment. However, it seems to be leaning
towards an explicit inflation target.)
7
My country had just gone through a severe currency and banking crisis – just like the UK which had adopted an inflation
target the year before Sweden. Look up ‘George Soros 1992’ for an account of what happened.
•
Evaluation of monetary policy
“If you have five dollars and Chuck Norris has five dollars, Chuck Norris has more money than you.” Anonymous
Monetary policy comes with a rather mixed bag of successes, limitations and trade-offs. While one can generally claim
that most countries have leaned more heavily on monetary than fiscal policies in later years, there is also no denying that
there is a good reason why not all countries have adopted inflation targets.
o Independence of the central bank
During the 1990s central banks saw increased independence in terms of the mandate to achieve set goals such
as growth, inflation and unemployment. The distortionary effects of governments using monetary policy for its
own gains were increasingly viewed by academics and policy-makers alike as outweighing the advantages of
using fiscal and monetary policies in a concerted effort to implement set policy goals. One key advantage put
forward by the monetarist/new-classical school is that the crowding out effect is avoided. Another is that one
can avoid a ‘political business cycle’ where different governments issue widely different policy objectives over
time. Finally, it seems empirically reasonably clear that increased central bank independence results in a lower
long run level of inflation.8 It should be pointed out that while central bank independence has always been
advocated by the monetarist/new-classical school it has become a rather mainstream view.9
o Time lags
Not all lags and concomitant difficulties in correctly timing contractionary and expansionary policies arise due to fiscal
policies. There are notable lags in monetary policy also, pointing to at least 2 quarters before interest rate changes take
full effect - and often as long as 6 quarters. The English central bank, the Bank of England, estimates that it takes at least
four quarters for a change in interest rates to affect inflation and over two years before maximum impact is reached.
8
See for example a study from the University of California at
http://people.ucsc.edu/~walshc/MyPapers/cbi_newpalgrave.pdf
9
See for example the view of the European Central Bank (ECB) at
http://www.ecb.int/press/key/date/2007/html/sp070419.en.html
o Keynesian view of monetary policy
As outlined in Chapters 45 and 46, the difference between the Keynesian and new-classical aggregate supply
curves have implications for economic policy. A key element in the Keynesian new-classical debate is whether
monetary policy is more effective than fiscal policy. The Keynesian view remains sceptical to the effectiveness
of monetary policy in adjusting aggregate demand by pointing out that an increase in the money supply does
not necessarily mean banks will lend out the excess in reserves. Another point is that while both consumption
and investment are indeed linked to interest rate changes, they are interest inelastic and thus there is limited
impact on these two key components of aggregate demand. It is for these reasons that Keynesian economics
focuses more on fiscal policy.
However…
Monetarists generally retort that even given the existence of a liquidity trap – by no means certain they say –
monetary policy is not without teeth even at zero or near-zero interest rates. Increasing money supply can fuel
expectations of households and firms, thereby fulfilling the criteria for expectations based increases in
aggregate demand.
o Limits of monetary policy
Monetary policy has shown severe limitations historically in dealing with deep recessions and supply-side
shocks. During the 1973-’75 period (the ‘First Oil Shock’) there were virtually no non-oil producing countries
spared the stagflation resulting from quadrupled oil prices. The aggregate supply shock in many cases led to a
cost-push spiral (see Chapter 53) and unforeseen levels of unemployment. This seriously limited monetary
policies since any attempts at contractionary monetary policies would have (at least initially) led to increases in
unemployment that society would have found unacceptable.
Yeah, I stole this. Any way to keep it? It’s all over the net.
“I just knew it was a liquidity trap!”
Deep recession and the liquidity trap
A key Keynesian argument is the so-called liquidity trap. This is a situation where any increase in the supply
of money has no effect on interest rates – the short term interest rate is zero. This negates any expansionary
monetary policy as illustrated in figure 59.5 where an increase in the supply of money (Sm0 to Sm1) has no
effect on interest rates. Since interest rates remain unchanged there is no decrease in savings or increase in
consumption/investment.
Figure 59.5 Liquidity trap
Interest rate
(%/year)
Sm0
Sm1
Increased supply of money..........no effect
on the rate of interest..........no change in
C or I in AD.
r0
Dm
Q0
Q1
Quantity of money ($bn/year)
During deep recessions central banks will commonly have lowered interest rates to fight possible deflation and
fuel consumption/investment. The problem is that when money supply has increased to the point where interest
rates hit zero, there is nowhere left to go. My grandfather, bless his Missouri rough-neck soul, would have
listened intently (beer and cigarette in hand) and said “Sounds like the injuns are still coming and you ran out
of ammo son!”10
Figure 59.6 The ‘Mankiw Rule of interest rates’ and de facto Fed rates, 1988 to 2011
Best disguise this a tad! Instead of
the text after the blue and red, use blue for “Interest according to Mankiw Rule” and for red “De facto Fed
interest rate”.
10
”Injuns” means Indians and ”ammo” is ammunition. My American-Irish family comes from the same patch of Missouri
woods as the James and Younger brothers – bandits, brigands, killers and cut-throats to the last man.
An interesting ‘test’ or ‘proof’ of the limits of monetary policy during deep recessions was provided by
professor Greg Mankiw at Harvard University at the start of 2012.11 He had earlier written a simple formula
suggesting that the Federal Reserve (the US central bank) set interest rates in accordance with:
Interest rate = 8.5 + 1.4(inflation – unemployment). This means that during high inflation and low
unemployment, interest rates are raised.
For example, at the start of 2011 inflation was 2.1% and unemployment 8.9%. This gives 8.5 + 1.4(2.1-8.9);
the interest rate should be minus 1.02 percent! Clearly not possible. This is illustrated in figure 59.6 where the
‘Mankiw Rule’ follows the de facto Fed rate very closely. That is, until the advent in 2008 of what would
become a severe recession. The discrepancy shows that the Fed rate basically hit zero while the ‘Mankiw Rule’
suggested far lower rates – e.g. negative rates of interest. The US hit a liquidity trap.
o Policy trade-offs
Finally, more trade-offs. In Chapters 48 and 57 five key trade-offs were identified, such as growth and
inflation, inflation and unemployment and domestic monetary policy and stability in the exchange rate. These
are all still relevant in the field of monetary policy:
•
•
Tight monetary policy (↑∆r or ↓∆Sm) aimed at…
o …decreasing inflation. This will contract economic growth and fuel unemployment. It can
also increase demand for the domestic currency and drive up the exchange rate.
o …appreciating the Home Currency. The trade-off is of course lower growth and higher
unemployment.
Loose monetary policy (↓∆r or ↑∆Sm) aimed at…
o …increasing growth and/or decreasing unemployment. This can lead to a decrease in demand
for the Home Currency and a depreciation of the exchange rate.
o …depreciating the exchange rate in order to increase exports and/or decrease imports. The
effect will be inflationary as both consumption and investment fuels aggregate demand.
Rory, lost track a bit. I don’t think I have cut the Pop Quiz below in before…but can’t remember.
POP QUIZ 3.4.1: DEMAND-SIDE POLICIES
1.
Explain how inflationary expectations in households might influence aggregate demand.
2.
How are the variables M, Y, CPI and transfer payments commonly affected during a recession?
3.
Explain how fiscal policy might be used in an economy showing increasing inflation.
4.
Draw four separate AS-AD diagrams (and perhaps supporting diagrams!) showing the effects of a) lower income
taxes, b) increased interest rates c) increased supply of money d) higher exchange rate.
5.
Explain why an increase in aggregate demand caused by increased government spending might not increase real
output in the long run. Use the AS-AD model in your answer.
6.
“The government raised interest rates today in response to a fiscal stimulus package presented by the Central
Bank.” What’s wrong with this picture? Look carefully.
11
See professor Mankiw’s page at http://gregmankiw.blogspot.com/2012/01/liquidity-trap-may-soon-be-over.html
7.
Why might aggregate demand fall as a result of falling property prices? Why might a decrease in aggregate
demand result in falling property prices?
8.
Canada and Mexico are trade partners. If Canada’s inflation rate increases at a faster rate than Mexico’s, ceteris
paribus, how might one expect aggregate demand to be affected in each country?
9.
A tricky one; in an economy the interest rate falls from 9% to 7% and at the same time the rate of inflation falls
from 8% to 5%. Explain why borrowers might in fact not be better off.
10.
Explain how the Central Bank could reduce the rate of inflation in the economy.
11.
Using the AS-AD model, evaluate the effects of monetary policies aimed at reducing inflation. NEW QUESTION!
12.
Using an appropriate diagram, explain why it might be very difficult for a central bank to stimulate aggregate
demand in times of severe recession. NEW QUESTION!
13.
Thinking ahead to Section 3 (trade): Assume that a decrease in the exchange rate (depreciation) has shown to have
a positive influence on aggregate demand in an economy due to a rise in export revenue and/or a decrease in
import spending. Might the inverse be true also, e.g. might increased national income instead affect a country’s
exchange rate?
Summary and revision
1. The real interest rate is defined as the nominal interest rate minus inflation.
2. Interest rates and investment expenditure (fixed capital) are negatively
correlated.
3. Loose monetary policy is either decreasing interest rates or increasing the supply
of money. Both policies have an expansionary effect on aggregate demand since
lower interest stimulates consumption and investment.
4. Tight monetary policy is raising interest or decreasing the supply of money. This
has a contractionary effect on aggregate demand as consumption and investment
fall.
5. Inflation targeting is when the central bank clearly states a given level of aimedfor inflation over a period of time. Since inflation figures are openly available it
allows stakeholders (firms and households) to plan ahead and anticipate central
bank actions.
6. Critique of monetary policy:
a. The degree of central bank independence influences monetary policies.
Generally, the freer a central bank is to set policy the greater the economic
stability.
b. Time lags in monetary policy can have the effect of exacerbating cyclical
variations in the economy just like fiscal policies.
c. Keynesians are traditionally sceptical about the general use of monetary
policy, citing that demand for investment is relatively inelastic and thus
insensitive to lower interest rates.
d. Another Keynesian point is that in severe recessions economies can wind
up in a so-called liquidity trap where interest rates are zero and increased
money supply therefore cannot stimulate increased consumption and
investment.
e. Monetary policy comes with the same trade-offs as in fiscal policy, namely
i. ↓∆ r → ↑∆ Y price stability and depreciation of the currency
ii. ↑∆ r→ ↓∆inflation growth and higher price of exports