Download Monetary Economics Lecture 1. October 30, 2007

Monetary Economics
Lecture 12. December 11, 2007
Robert TCHAIDZE
December 11, 2007
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Issues to Discuss
1. Monetary transmission channels
(Mishkin 1995, Journal of Economic
Perspectives Symposium)
2. Operational procedures
3. Monetary policymaking questions (Alan
Blinder “16 questions and about 12
answers”)
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Monetary Transmission
•
•
•
Changes in monetary policy variables (i.e. monetary
aggregates and interest rates) affect economy through
various channels.
Magnitude and order of importance of these channels
are debated.
These channels are:
1. Interest rate channel
2. Exchange rate channel
3. Credit channel
1. Bank lending channel
2. Balance sheet channel
4. Asset price channel
5. Expectation channel
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Interest Rate Channel
• Mechanics:
– Money supply decreases →
– Interest rate increases →
– Investment decreases and so does output
• Initially was thought to be affecting firms.
• Later it was recognized that this channel affects
as well consumer spending, such as residential
construction and consumption of durables.
• John Taylor argues this channel has strong
affects, while Bernanke and Gertler argue that
empirical studies do not confirm this.
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Exchange Rate Channel
• Mechanics:
–
–
–
–
Money supply decreases →
(Interest rate increases →)
Exchange rate appreciates →
Net exports decrease and so does output
• There is an agreement on importance of this
channel. Movements in exchange rate affect
economy in several ways:
– Cost of imported goods, whether final consumption or
production inputs;
– Competitiveness of exports and import substitutes;
– Balance sheets (in case of liability dollarization).
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Asset Price Channel
• Mechanics:
– Money supply decreases → Expected prices,
including stock, decrease →
• Either because public has less money (monetarist
view) or because interest rate increase reduces
demand for equity (Keynesian)
– Tobin’s q decreases → Investment decreases
and so does output.
• An alternative channel works through
wealth effect impact on consumption.
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Bank Lending Channel
• Mechanics:
– Money supply decreases → Deposits decrease →
Bank loans decrease → Investment and consumption
decrease and so does output
• Puts emphasis on quantity not price.
• Matters for small firms as big firms can raise
funds directly via equity issuance.
• It has been argued that given innovations in
financial markets, this channel is likely not to be
too important. But it may remain so in countries
with underdeveloped financial markets.
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Balance Sheet Channel
• Emphasizes the changes in net worth, which
impact borrowing constraints.
– Money supply decreases → Expected prices and net
worth decrease → Adverse selection and moral
hazard problems intensify → Lending decreases →
Investment decreases and so does output.
• Another impact is via cash flow.
– Money supply decreases → As interest rates rise,
cash flows decrease → Adverse selection and moral
hazard problems intensify → …
• Likely to affect consumers as well.
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Operational Procedures
•
Three instruments:
1. Open market operations;
2. Setting required reserves ratios;
3. Lending via Discount window.
•
•
Mostly used is the first with an aim of
affecting overnight interest rate at the
interbank market.
Open market operations happen usually
in REPO market.
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Financial System
• The system comprises of commercial (deposit
money) banks, mortgage credit institutions and
other financial institutions, such as pension funds,
mutual funds, insurance companies, etc.
• Banks need liquidity for conducting transactions
on behalf of their clients, conducting transactions
with each other, or for their own activities.
• Central Bank needs to evaluate amount of liquidity
demanded and amount of existing liquidity and if
necessary conduct open market operations.
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Role of a Central Bank
1. Source of liquidity (money) via open market
operations or as a lender of last resort;
2. Banker of banks, which keep reserves in the
central bank, used for settling transactions with
each other, the CB, and the government;
3. Clearing house for banks, which conduct
transactions with each other;
4. Agent of the fiscal authorities;
5. Maintenance of foreign exchange reserves.
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Policymaking. Blinder’s Questions
Institutional Design
1. What is the proper objective function for monetary
policy?
2. How transparent should the central bank be?
3. Should the central bank be an inflation targeter, as
that term is commonly used nowadays?
4. Should monetary policy decisions be made by a
single individual or by a committee – and, if the latter,
what type of committee?
5. Should the central bank also regulate and/or
supervise banks?
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1. Objective Function
• In academic papers mostly common is the
loss function (π – π*)2 + λ (y – y*)2
• What should λ be?
• How to estimate y*?
– y* = AF(L*(1 – u*), K)
– Mechanic trends
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1. Objective Function
• What should number π* be?
– Most of CBs target 2%. Not lower because indices
are biased upwards; to avoid deflation and liquidity
traps
• What measure of inflation to use?
– PPI/CPI, wages/prices, include or not asset prices?
– Core or headline, i.e. exclude or include energy and
food prices?
• Most of CBs choose headline inflation
• Monetary policy is unlikely to have much of an impact over
energy and food
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2. Transparency
• Paraphrasing Einstein: Every Central Bank
should be as transparent as possible, but
not more so.
• Expectations and democratic
accountability.
• Forecasts based on …
– … unchanged monetary policy?
– … path expected by the markets?
– … CB’s own (conditional) forecast?
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Other Institutional Questions
• Inflation targeting
– Widespread and gaining popularity but …
• Committee or single individual
– Pooling of information; Diversity of
backgrounds, methods, and approaches;
Checks and balances.
• Supervision
– Separate or not?
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Policymaking. Blinder’s Questions
Operating Principles
6. Is the observed proclivity of central bankers to avoid
policy reversals justifiable?
7. Does the revealed preference of central bankers for
gradualism make sense?
8. Is “fine tuning” possible after all? And if so, should
central bankers attempt to fine-tune their economies?
9. Should central banks lead or follow the financial
markets?
10. Should central banks in floating exchange rate
regimes intervene in the foreign-exchange market?
11. Should central banks use derivatives in the conduct of
monetary policy?
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Policymaking. Blinder’s Questions
Transmission Mechanism
12. Transmission through the term structure of
interest rates
13. Transmission through the exchange rate
14. How should the central bank deal with
asset-market bubbles?
15. How should the central bank deal with the
zero lower bound on nominal interest rates?
16. Do the world’s giant central banks have
global responsibilities?
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