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Transcript
Contribution of Monetarism in Macroeconomic Policy • Supply of money is the determinant of the national income • In the long run, the influence of money is primarily on the price level and other nominal magnitudes. Real output and employment are not determined by monetary factors. • In the short run the supply of money does affect the output. Money is the dominant factor in causing cyclical fluctuations in output and employment in the short run. • Private sector is inherently stable and instability is primarily the result of the government policy. Macroeconomic Themes:3 1 Policy conclusions • Stability in the growth rate of money supply is crucial for a stable economy. Monetarists favour a constant money growth rate policy rule rather than discretion. • Fiscal policy does not have any systematic impact on real or nominal income. Macroeconomic Themes:3 2 The basic mechanism of money supply Households and firms save part of their income. They also borrow from their banks if their savings are not enough to meet their expenses. If deposits are not enough these banks borrow from the central bank. Central bank lends them by creating reserves at a prespecified interest rate. By doing so it adds to the monetary base. Given the money multiplier this translates into the overall supply of money. This supply along with the given demand for money by the private sector determines the market interest rate as well as the price level. Households and firms revise demand for loans based on these new interest rates and prices. Macroeconomic Themes:3 3 The basic mechanism of money supply Government similarly can approach the central bank to finance its deficit. Central bank creates reserves while lending to the government. This also raises money supply. A central bank also buys foreign currency and sells domestic currency. Money supply expands when economy activities rise and contracts when they slow down. Central bank alters the interest rate to increase or reduce the liquidity required in the economy. Macroeconomic Themes:3 4 Money Supply Various types of money: M0, M1, M2, M3, M4 ; m 1r Money multiplier: If we considering a leakage in the currency holding: m 1r cc M R C 0 M4 C D (a) (b) M D C 1 c then dividing (b) by (a) 4 . M C R cr 0 If people held more currency then multiplier becomes Macroeconomic Themes:3 smaller. 5 Money Demand Quantity theory of Money (QTM): MV = PT Cambridge equation of money demand: M kY => M 1 PY P k Keynesian money demand M b b Y b r P t 0 1 t 2 t Friedman type money demand M kPY => M k r e , r b , r D , r PY Macroeconomic Themes:3 6 Friedman (1968) on Monetary Policy Given the natural rates of interest and unemployment, monetary policy cannot be pegged to lower the interest rate or the unemployment. Is so it only raises inflationary expectation and increase in price level. There will be no impact on real magnitudes. Monetary authority can control nominal quantities such as it liabilities, M0, M3 or M4. By controlling them it can stabilise the price level. Price mechanism in the market system works better when prices are stable and relative prices can adjust according to the dynamics of the economic system. Macroeconomic Themes:3 7 Natural Rate Hypothesis t e bu t u n f LPC g d e b c PC4 PC3 Un Short run Phillip’s curve PC a PC2 u un PC1 Natural rate of unemployment and a vertical Phillip’s curves Macroeconomic Themes:3 8 A brief story of monetary policy in the UK and the EU Fixed peg system in the Gold Standard and the Bretton Woods. Exchange rate was the nominal anchor of monetary policy. Targeting money supply during 1970s. Stop and Go Cycles. Monetarism in the Thacher and Reagan administrations. Inflation targeting during 1980s. Central bank independence during 1990s. Euro 1999. Macroeconomic Themes:3 9 retail price index and growth rate of money supply -5 Macroeconomic Themes:3 10 1998Q4 1997Q2 1995Q4 1994Q2 1992Q4 1991Q2 15 1989Q4 20 1988Q2 1986Q4 1985Q2 1983Q4 1982Q2 1980Q4 1979Q2 1977Q4 1976Q2 1974Q4 1973Q2 1971Q4 1970Q2 Inflation and growth rate of money supply in the UK 1972-2000 30 25 rpi msgrth lagp 10 5 0 -2 -4 Macroeconomic Themes:3 -6 growth rate 11 1998Q4 1997Q2 1995Q4 1994Q2 1992Q4 1991Q2 1989Q4 1988Q2 1986Q4 1985Q2 1983Q4 1982Q2 1980Q4 1979Q2 1977Q4 1976Q2 1974Q4 1973Q2 1971Q4 1970Q2 Growth Rate fo real GDP in the UK 12 10 8 6 4 2 0 How does the Bank of England forecast the inflation? The economic model of the Bank of England includes a loss function, policy reaction function and intermediate targets. Core forecasting model that the MPC uses for interest rate decisions includes 150 variables. But the model for the pre-MPC briefing is based on charts and tables of more than 1000 variables. Information for this model is collected from 12 different branches of the bank around the country. Inflation target focuses on the domestically generated inflation (DGI). (John Vickers, Inflation Targeting in the UK,Bank of England Quarterly Bulletin, 1999 pp. 368-375). The forecasting model might be summarised in terms of the following diagram from the MPC. Macroeconomic Themes:3 12 Transmission Mechanisms of Monetary Policy-Bank of England’s View Market rate Official rate Total demand Asset prices Expectations and confidence Domestic inflationary pressure Domestic demand Inflation Net external demand Import prices Exchange rate Macroeconomic Themes:3 13 Bank of England’s Fan Chart Percentage increase in prices on a year earlier Macroeconomic Themes:3 Source: Inflation Report, Bank of England, November 2000 B&W Figure 9.7 14 Effects of Changes in the Rate of Interest First round effects Households: saving, housing, wealth, foreign asset, portfolio allocations Firms: cost of capital, debt-equity, portfolio allocations Second round effects: consumption spending, additional demand for goods Time lags: anticipated and unanticipated policy changes. Macroeconomic Themes:3 15 Simple Policy Reaction Function: An Example of Interest Determination Rule Impact of interest rate in output * * yt y d i it (1) t 1 where it and it* are actual and natural level of output, it is the actual rate of interest in period t, i is the interest target of the monetary authority, d <0 is a negative parameter. There is one period lag between the interest rate decision and the change in the output. Macroeconomic Themes:3 16 Simple Policy Reaction Function: An Example of Interest Determination Rule The inflation rate responds to the aggregate supply * * t t c y y (2) t 1 t 1 where t and t* are actual and target inflation rates Therefore the interest rate determination rule in simple terms can be written as * * * it it a yt yt b t t (3) Macroeconomic Themes:3 17 Output Does Policy Work? Lags and demand management policy B amplified cycle Business cycle A smoother cycle Macroeconomic Themes:3 Time 18 Monetarist’s View on Impact of Monetary and Fiscal Policies Monetarists view of Monetary policy (IS-LM) Monetarist view on Fiscal policy (IS-LM) Macroeconomic Themes:3 19 Monetary Policy Instruments Money supply targeting Interest rate targeting Macroeconomic Themes:3 20 Interest Rate Determination Model: Actual and Predicted Series 18 PTBIL TBILLS 16 14 12 10 8 6 4 2 0 0 20 40 60 TIME 80 Macroeconomic Themes:3 100 120 21 Prediction using a Simple Model Interest Rate Determination Rule : A Simultaneous Equations Estimation 25 PTBIL TBILLS 20 15 10 5 0 -5 -10 0 20 15 40 60 TIME PDRPI DRPI 80 100 120 8 10 PDY DY 6 4 5 2 0 0 -2 -5 -4 -10 0 20 40 60 TIME 80 100 120 -6 0 Themes:3 20 Macroeconomic 40 60 TIME 80 100 120 22 References 1. 2. 3. 4. 5. 6. Ball Laurence and Romer David (1990) Real Rigidities and the Non-Neutrality of Money, Review of Economic Studies, 1990 57 183-203. Bank of England (www.bankofengland.co.uk) The Transmission Mechanism of Monetary Policy. Barro and Gordon (1983) A Positive Theory of Monetary Policy in a Natural Rate Model, Journal of Political Economy, 91:4: 589-610. Goodhart C.E.A. (1994) What should central banks do? What should be their macroeconomic objective and operations?, Economic Journal, 104, November, 1424-1436. Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII March. Kydland F.E and E.C. Prescott (1977) Rules rather than discrection: the Inconsistency of Optimal Plans, Journal of Political Economy, 85:3: 473-491. Macroeconomic Themes:3 23