Monetary Economics

5/8/2013
1
Monetary Economics;week 3 Monetary Policy Instruments Charles vanMarrewijk, 2013;1
MONETARYECONOMICS2013
CharlesvanMarrewijk;MonetaryPolicyInstruments
Aboutme
Transmissionchannels
Credibilityandpolicyframework
Instruments,targets,anduncertainty
Quantitytheory(longrun)
Interestrates(shortrun)
Internationalbankingempirics
Expectations(fromtargetstoobjectives;Phillipscurve)
Expectationsformation(empiricalPhillipscurves)
Objectivesofcentralbanks
Longrunversusshortrun
CharlesvanMarrewijk
ProfessorofInternationalMacroeconomicsatUtrechtUniversity
DirectorTjalling CharlesKoopmansResearchInstitute
Education:
lotsof"highschools"(MAVO,HAVO,RMTuS,VWO)
BA+MAEconomics,Erasmus University,theNetherlands
MSc+PhDEconomics,Purdue University,USA
Longertermvisits:
Cornell,Yale,Princeton(USA),Cambridge(UK),Voronezh(Russia),St
Louis,Benguet State,Xavier(Philippines),Adelaide(Austr.)
Personal:MarriedtoMira(alovelyFilipina)
Fourchildren:Ken(26),Cynthia(22),Nino(20),andMarco(almost2)
Publications:journalarticles(int ec,geogr.,growth,devel.,macro,
micro,ind. org.);books(Growth,Transfers,Global,Geography,
InternationalTrade,Globalization,InternationalMoney,Macro)
CharlesvanMarrewijk;books
OxfordUnPress
IntTrade2002
IntEconomics2007
IntEconomics2012
CambridgeUnPress
IntTransfers1998
Geographicalec2001
Nations&firms2006
Geographicalec2009
Intec&bus2013
Aboutme
Chapter4MonetaryPolicyTransmission
Threetransmissionchannels
Quantitytheory:directimpactofmoneysupplyonmacrodemand
Interestrate:impactofchangesininterestratesoninvestments
andothercomponentsofdemand(IS/LM,Tobinsq,yieldcurve)
Expectations:impactofinflationexpectationonwagenegotiations
(Phillipscurve,supplyside)
Practicalcaveatsformonetarypolicyfinetuning
Modeluncertainty;whatistherightmodel,whatistheright
econometrictechniquetotestandestimateit
Longandvariablelags;lagbeforechangeinsituationisrealized
lagbeforeactionistaken(policychange) lagbeforeactiontakes
effect;altogethermakescountercyclicalpolicydifficult
Aboutme
5/8/2013
2
International Economics Van Marrewijk, 2012 Page 7
Credibility
With smart economic agents credibility of government policy
is crucial for determining its effectiveness.
The objective of most Central Banks is to keep inflation in
check. Sometimes they also need to keep unemployment
down. Central Banks do not have direct control over these
economic variables however.
Central Banks only have direct control over their
instruments (such as minimum reserves or standing facilities).
They can use these instruments to influence intermediate
targets (interest rate or money stock), which affect the
objectives. A Central Bank can therefore never be 100% sure
that its objectives will be reached.
In this chapter we will analyse the policy framework and
theories which explain the transmission channels from
instruments to targets and from targets to objectives.
The economic policy framework
If you want to influence the outcome of an economic process,
you have to take the following steps:
1. Specify your objectives (we focus on benevolent individuals
and institutions)
2. Find (economic) targets that indicate to what degree the
objectives are reached
3. Determine the instruments to actually influence the targets

Instruments Objectives
(final)
Targets
(intermediate)
transmission
process 1
transmission
process 2
e.g. minimum
reserves, standing
facilities, or open
market operation
e.g. interest rate or
money stock
e.g. social welfare
based on output,
employment,
inflation, etc.
feedback
Instruments Objectives
(final)
Targets
(intermediate)
transmission
process 1
transmission
process 2
e.g. minimum
reserves, standing
facilities, or open
market operation
e.g. interest rate or
money stock
e.g. social welfare
based on output,
employment,
inflation, etc.
feedback
Aboutme
Instruments of the Central Bank
Most Central Banks have the following instruments:
Standing facilities for refinancing purposes: Credit line at a
given interest rate (upper limit of money market rate)
Standing facilities for absorption purposes: Debit facility at a
given interest rate (lower limit of the money market rate)
Outright open market operations: Buying and selling of
securities.
Securities repos: Temporary borrowing or lending of money
with securities as collateral
Minimum reserve requirements: Minimum reserves a
commercial bank must hold at the Central Bank
From instruments to targets
The instruments of the Central Bank have a direct effect on
the narrow money market. Indirectly they also influence the
money supply and interest rate on the broad money market.
The Central Bank may target the monetary base (open
market operations, securities repos and reserve
requirements) or the interest rate (standing facilities).
The demand for money is a downward-sloping function of the
interest rate. In absence of uncertainty and shocks the
monetary base and inflation rate targeting are equivalent.
From instruments to targets under uncertainty
In practice the demand function is likely to fluctuate in
response to uncertainty and shocks. In this case interest rate
targeting (monetary base absorbs shocks) or monetary base
targeting (interest rate absorbs shocks) matters.
i
res
B
B
d
0
i
res,0
B
0
i
res
B
i
res,0
B
0
B
d
0
Monetary base
targeting
Interest rate
targeting
5/8/2013
3
Aboutme
Quantitytheory;HI = P
P
Y
P
0
P
1
Y
S
Y
D0
=M
0
V/P
Y
D1
=M
1
V/P
Highermoneysupplymeans:
Higherprices(longrun)
Moneygrowthandinflation
positivelycorrelated(especially
underextremecircumstances),but
actualtransmissionchannel
(whoreceivesmoneywhenandhowand
whatistheimpact)notincluded
Aboutme
Interestrates;transmissionchannelthroughspendingcomponents
y
t+1
= [
1
y
t
-[
2
i
t
-n
t
+ [
3
x
t
+ p
t+1
Real(log)outputrelativetopotentialoutputtargetedwithshortterm
realinterestrate(oneyearlag);x exogenouscomp.,etarandomshock
i
Y
IS
0
IS
1
LM
0
LM
1
i*
i'
i"
E
0
E
1
E
2
ExogenousISshock
cannotrestoreeqoutput
(stickyprices,shortrun)
Activemonetary
policyrequired
shiftsLMcurverestores
outputeq
DerivationofLMcurve
basedonmoneyview
(USA)orcreditview(EU)
Indirect(shortrun)
effectofionprofits
(throughleverage)
Aboutme
1900 1960 1950 1910 1940 1920 1930 1980 1990 1994 1995 1970
0
60
USRelativesharesoftotalfinancialintermediateassets,19001995
50
40
30
20
10
Commercialbanks
Pension,trust,and
investmentcompanies
Thriftandfinance
companies
Insurance
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BankvalueaddedasashareoffinancialsectorGDP;constant
Banksarenolongertheprimarysourceofbusinessandconsumer
financenorthemainrepositoryofliquidsavings;theyaremuchless
dependentontraditionalintermediationincome;innovation fees
Valueandnumberofacquisitionsofbanksin
developingcountriesbysourcecountry,19902003
USandSpainmostactive
0
10
20
30
40
50
60
70
80
90
1994 1999 2004
Commercialbanksbytypeofownership;LatinAmerica(%)
privatedomestic
foreignowned
stateowned
Substantialrise
foreign
Mainlyatexpense
domestic
0
10
20
30
40
50
60
70
80
90
1994 1999 2004
Commercialbanksbytypeofownership;CentralEurope(%)
privatedomestic
foreignowned
stateowned
Substantialrise
foreignto4/5
th
atexpenseofboth
domesticandstate
0
10
20
30
40
50
60
70
80
90
1994 1999 2004
Commercialbanksbytypeofownership;ChinaandIndia(%)
privatedomestic
foreignowned
stateowned
Noriseforeign
Somerisedomestic
atexpensestate
0
10
20
30
40
50
60
70
80
1994 1999 2004
Commercialbanksbytypeofownership;OtherAsia(%)
privatedomestic
foreignowned
stateowned
Noriseforeign
Somerisestateat
expensedomestic
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5
0
10
20
30
40
50
60
70
80
90
1994 1999 2004
Commercialbanksbytypeofownership;OtherEMEs(%)
privatedomestic
foreignowned
stateowned
Noriseforeign
Somerise
domesticat
expensestate
Episodesofexpandedglobalbanking
CollapseSovietUnion1989leadstobreakupandfallironcurtain;
manycountriesincentralEuropeenterEU(2004,2007)andallow
foreignownershipinnationalbankingduringthe1990s
LiberalizationoffinancialsectorinLatinAmericancountriesduring
1990s;firstfollowyourcustomertype,thenrecapitalizationafter
financialcrises
SpainisactiveinLatinAmericaforhistoricalreasons(closelinks)
22,424
2,152
3,809
Locationofforeignclaimsbynationalityofrepbanks,2007(US$bn)
Advancedcountries
Offshorecenters
Developingcountries
6
8
6
81
Locationofforeignclaimsbynationality(%,2007)
USbanks
Japanbanks
Otherbanks
Europeanbanks
Aboutme
Expectations (from targets to objectives)
The interest rate and money supply on the broad money
market (targets) influence the inflation and unemployment
rate in the economy (objectives).
Inflation (%)
Unemployment (%)
3 5 7
0
4
6
2
61
69
65
Phillips curve
A
B
Alban Phillips discovered there is also a
relationship between inflation and
unemployment, the Phillips curve.
The Phillips curve suggests a policy trade-off
between inflation and unemployment,
provided that the relationship is stable.
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Stability of the Phillips curve
The Phillips curve turned out to be unstable however. The
curve has shifted over time.
3 9 5 7
0
8
10
4
6
2
1960s
1970s
1980s
1990s
61
69
65
71
75
79
74
81
82
84
89
87
92
95
99
Unemployment (%)
Inflation (%)
U: Unemployment
U
n
: Natural rate of unemployment
: Inflation
e
: Expected inflation
Expectations augmented Phillips-curve
The expectations augmented
Phillips-curve shows that
deviations from the natural rate
of unemployment are possible
when expected and realized
inflation differ.
An unexpected jump in
inflation will decrease
unemployment.
) (
e
n
a U U
Figure 28.7 The expectations-augmented Phillips curve
Aboutme
Expectations;
OriginalPhillipscurve(Phillips,1958):relatesnominalwage
changesandunemployment
ModifiedPhillipscurve(Samuelson&Solow,1960):usesmarkup
pricingtorelateinflationrateandunemployment
ExpectationsaugmentedPhillipscurve(Friedman,1968,and
Phelps,1967):relatesshortrunPhillipscurvetoexpectations
formationand(longrun)naturalrateofunemployment
Underlyingexpectationsformationistheproblem
ofstickyprices(alsonextslide)
Underlyingstickypricesismenucostsfor
changingprices,overlappingcontracts,etc.
Sticky prices (relative to exchange rates)

Eurozone; price and exchange rate flexibility (% change, monthly data)
-8
-6
-4
-2
0
2
4
6
8
1999 2001 2003 2005 2007 2009 2011
USD/EUR change
price
change
5/8/2013
7
Expectationsformation;
Extrapolative;expectedinflationtodayisinflationyesterday,or
weightedaverageofpastinflation:n
t
c
= o
n
t-
n
=1
Adaptive;expectedinflationtodayisexpectedinflationyesterday,
adaptedforyesterdaysforecasterror:
n
t
c
= n
t-1
c
+ [ n
t-1
-n
t-1
c
(adaptiveandextrapolativeisessentiallythesame:backwardlooking)
Rational;agentsformexpectationsbasedontheeconomicmodel
itself,Muth(1961).
BofingersdiscussioninCh4israthersupportiveofextrapolative/
adaptive expectationsempirically thatiscruciallymissingthepoint:
undernormal circumstancesthisisasexpected.However,authorities
thatwanttobuildonorexploit theseexpectationscangetawaywith
itforever underextrapolative/adaptiveexpectations,butnot under
rational expectations(BobMarleyprinciple:youcanfoolsomepeople
sometime,butyoucannotfoolallthepeopleallthetime)
Figure 28.8 The Phillips curve; USA, UK, Italy, and Japan, 1990-2009

a. Phillips curve USA
-2
0
2
4
6
8
10
0 2 4 6 8 10 12
unemployment (%)
in
fla
tio
n
(
%
)
1990
2009
2000

b. Phillips curve UK
-2
0
2
4
6
8
10
0 2 4 6 8 10 12
unemployment (%)
in
fla
tio
n
(
%
) 1990
2009
2000
Figure 28.8 The Phillips curve; USA, UK, Italy, and Japan, 1990-2009

c. Phillips curve Japan
-2
0
2
4
6
8
10
0 2 4 6 8 10 12
unemployment (%)
in
fla
tio
n
(
%
)
1990
2009 2000

d. Phillips curve Italy
-2
0
2
4
6
8
10
0 2 4 6 8 10 12
unemployment (%)
in
fla
tio
n
(
%
)
1990
2009
2000
Aboutme
L: Loss of the Central Bank
U: Unemployment
U*: Target rate of unemployment
: Inflation
*: Target rate of inflation
Objectives of the Central Bank (chapter 5)
The loss function of the
Central Bank indicates the loss
suffered from deviations from
target inflation and
unemployment.
The Central Bank wants to
minimize this function.
If b=0 the Central Bank has a
strict inflation target and if b>0
a flexible inflation target.
(if b=1 nominal income target)
2 * 2 *
) ( ) ( U U b L
Numerical inflation targets in 2011
Table 28.1 Numerical inflation targets in 2011
Central bank Inflation target (percent)
Bank of Canada 1 3, aimed at midpoint
Bank of England 2 (+1)
European Central Bank below (but close to) 2, medium term
Reserve Bank of Australia 2 3, on average, over the cycle
Reserve Bank of New Zealand 1 3, medium term
Sveriges Riksbank 2 (+1)
Sources: websites of national banks, 15 August 2011.
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Wet- and hard-nosed authorities
a. 'hard-nosed' preferences
iso-loss curves, b = 0.5
-3
-2
-1
0
1
2
3
0 1 2 3 4 5 6
unemployment
in
f
la
t
io
n
U
*
bliss
b. 'wet' preferences
iso-loss curves, b = 3
-3
-2
-1
0
1
2
3
0 1 2 3 4 5 6
unemployment
in
f
la
t
io
n
U
*
bliss
Hard-nosed authorities mainly care about inflation (b is low)
and wet-nosed authorities also take unemployment into
consideration (b is high).
The Federal Reserve System in the US is more wet-nosed
compared to the European System of Central Banks.
Aboutme
Focusonlongrunpricestability(lowinflation)
Costsofinflationrelatedtodeviationsfromexpectations(deviations
morelikelyandlargerwithhighinflation)
Menucosts(needtochangepricesmoreoftenwithhighinflation;more
difficulttoengageinlongertermcontracts)
Taxsystemdistortions(e.g.nominalscalescreatehighertaxburdenwith
highinflation;alsoinefficientallocationofcapitalwithtaxdeductablehigh
nominalinterestrates)
Empiricalevidencestronglysuggests:lowereconomicgrowthwith
higherinflationrates(doesnotincludeallcosts);effectismodestfor
modestinflationrates,butbecomeshugeforhighinflationrates
Measuredinflationtoohighfor4mainreasons:
Qualitybias(higherqualitynewgoodsnotreflectedinprice)
Productsubstitutionbias(substituteawayfromexpensivegoods)
Newgoodsbias(newgoodsdidnotexistbefore,relatedtoqualitybias)
Outletsubstitutionbias(buygoodsatstoreswithlowestprices)
i
Y
P
Y
v
P
0
]
Shortrun KeynesianISLM
ASADframework
IS
0
IS
1
IH0
H0
P0 IH0
H0
P1
IH0
H1
P0
AS
A
0
A
1
A
2
0 = ]
1
Nominaltargetishyperbola
Demandshock(investmentfalls)
ADshiftsleft,newP,shiftLM
P
0
P
1
WithnominalGNPtarget
mustshiftbacktoP
0
0
Withpriceleveltargetmust
shiftbacktoP
0
(same)
Withdemandshocksno
conflictbetweenreal
target,pricetarget,
nominaltargeting
(alsosameforrealtarget)
i
Y
P
Y
P
0
]
SupplyshockshiftsASleft
IS
0
IH
H0
P0
IH
H0
P1
=IH
M]
P]
A
0
A
]
A
p
0 = ]
1
P
0
P
1
AS
0
AS
1
IH
Hp
P0
P
]
HigherP,shiftsLMleft,
outputgapresults
p
Ifrealtarget:shiftADright=
shiftLMright,raiseM,even
higherprices(bluedot)
Ifpricetarget:shiftADleft=
shiftLMleft,lowerM,even
higheroutputgap(reddot)
IfnominalGNPtarget:
compromise betweentwo
extremes(inthiscaseslight
reductionmoneysupply,
slightincreaseoutputgap;
greendot;detailsnotshown)
Variationsinlossfunction
bor(Bofinger)make
othershortrun
compromisespossible

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