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Stabilising the economy: Central Banks and Monetary Policy MSc EPS Session 4 Hilary term 2013 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 OUTLINE Price stability defined Why is price stability important? Role of Central Bank – a broader remit than price stability? Monetary policy – objectives and instruments Effectiveness of monetary policy New thinking on banking and central banks 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) Why not CPI target of 0%? Composition bias Quality bias Substitution bias Importance of “medium term” – Bank must not overreact to short term upsurge 5 WHAT CAUSES INFLATION? Inflation is always and everywhere a monetary phenomenon (Friedman) Demand shocks (property price boom) Supply shocks (food, energy price increase) Budget deficit Money supply, increase in loans 6 ECONOMIC COSTS OF INFLATION pp 284-286 Inefficiency effects Redistributive wealth effects Adverse dynamics – inflationary spiral Costly to restore price stability 7 QUESTION FOR CLASS DISCUSSION Deflation also a problem Can be even more damaging than inflation Can you explain why? 8 TASKS OF CENTRAL BANK Monetary policy Official foreign reserves Exchange rate defence Lender of last resort Government banker 9 THE CENTRAL BANK Price stability – ultimate objective Intermediate variables to monitor: Money supply Growth of credit Capacity utilisation Commodity prices Order books Exchange rate 10 Speech given by Mervyn King, Governor Bank of England, Belfast 22 January 2013 11 THE CENTRAL BANK (2) Price stability – ultimate objective …. and , by adhering to this objective , Central Bank will make maximum contribution to overall macroeconomic stability. 12 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 5,190 €9,430bn Memo: GDP 2008 = €9,200 bn 13 POLICY INSTRUMENTS OF CENTRAL BANK Open market operations Interest rate pp318-333 Minimum reserve ratio ----------------------------------------Intervention in forex markets Direct controls -------------------------------------------Unconventional measures 14 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 15 Key Policy interest rate ECB: main refinancing rate BoE: official bank rate Fed: target rate 01/01/2011 01/01/2010 01/01/2009 US 01/01/2008 01/01/2007 BoE 01/01/2006 01/01/2005 01/01/2004 01/01/2003 01/01/2002 01/01/2001 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 01/01/2000 ECB 16 INTEREST RATES AND ECONOMIC ACTIVITY (pp 315-318) THE MONETARY TRANSMISSION MECHANISM 17 MONETARY POLICY AND REAL GDP 1. Substitution effect (-) i (-) S, (+) C 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 (+) C 4. (+) I Cost of Capital (Investment) effect (-) i (+) I 18 MONETARY POLICY AND REAL GDP 5. Exchange rate effect (-) i depreciation of real exchange rate 6. CB credibility effect (-) i (+) domestic confidence 19 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 20 HOW MONETARY POLICY COMBATS INFLATION Fig 13.6 p 321 Tighten monetary policy 21 If actual output > potential output, restrictive monetary policy will reduce dangers of inflation Objective is to secure a soft landing …. 22 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? 23 Limitations of monetary policy in dealing with Deflation • Nominal interest rate cannot go below zero (ZIRP) • When prices are falling, real interest rate can stay high even as nominal rate falls • Hence monetary policy may not have sufficient stimulative impact to combat recession • FUNDAMENTAL LIMITATION: expansionary monetary policy encourages spending --- but it cannot force people to borrow and spend (Also potential danger of overstimulus causing inflation) 24 Reform of the Financial Sector also needed 1. “Too big to fail” banks must be taxed to compensate taxpayer for implicit government guarantee: “specific capital surcharges for systemically important financial institutions can be a useful tool and should be accompanied by resolution plans vetted by regulators” (OECD). 2. Structural separation between retail and investment banking also needed 3. Reduce incentive to get too big to fail by taxing the equivalent of the implicit guarantee. 4. Improve supervision and incentives system 25 26 Quantitative Easing a) What is it? b) Can it help to restore credit growth? 27 Limitations of monetary policy in dealing with Inflation • High nominal interest rate may be needed to curb over optimism and restore balance • Danger or over reaction to short term price changes • Insufficient attention to asset price movements 28 Questions for Group work 1. Define price stability. Why is attainment of price stability important? 2. What intermediate targets can a central bank set to ensure that price stability is maintained? 3. What policy actions can a central bank take to preserve price stability? 4. Would a cut in interest rates be an effective way of stimulation aggregate demand in the Euro Area? 5. Does business prefer rising prices (inflation) to falling prices (deflation)? Or are both equally undesirable? Explain. 29 Questions for Group work (2) Exercise 3 p. 304 30 CONCLUSIONS Price stability is good for economic growth Deflation is just as damaging as inflation Aggressive monetary policy necessary to avoid booms and busts But not always sufficient ... In times of crisis, fiscal policy also needed 31 G20 COMMUNIQUE LONDON APRIL 2009 Monetary Policy in Action 32 G20 COMMUNIQUE LONDON APRIL 2009 33