Adobe Systems Monetary Policy 1 Economic Policy Monetary Policy Adobe Systems Monetary Policy 2 Content ̶Introduction ̶ ̶Objectives ̶ ̶Instruments ̶ ̶Institutions ̶ ̶Transmission channels ̶ Adobe Systems Fiscal Policy 3 Stabilization Policy ̶aim: maintain a healthy level of economic growth and minimal price changes; to smooth the economic cycle Adobe Systems Monetary Policy 4 Overview ̶Money is old device, but the concept of monetary policy (MP) emerged during interwar period ̶ ̶It emerged after hyperinflation experiences of the 1920s and the Great Depression in 1930s ̶ ̶During 50s and 60s MP was eclipsed by fiscal policy and primarily concentrated on minimizing the cost of public borrowing ̶ ̶In the 70s the role of MP was reassessed as a consequence of the made in the response of the inflationary shocks (+ independence) ̶ ̶By the late 90s MP geared toward achieving price stability ̶ ̶Financial crisis in 2008 highlighted the role of CB as guarantors of financial stability, CB engaged in unconventional MP actions Adobe Systems Monetary Policy 5 Overview Adobe Systems Monetary Policy 6 Terms ̶inflation = an increase in the general price level in the economy ̶ ̶zero inflation = constant price level ̶ ̶deflation = price level falls ̶ ̶rising inflation = the price level is increasing at an increasing rate ̶ ̶disinflation = falling inflation (the inflation rate is falling) ̶ ̶core inflation = change in the costs of goods and services but does not include those from the food and energy sector Adobe Systems Monetary Policy 7 What’s wrong with inflation? ̶redistributing income from creditors and those on nominally fixed incomes to debtors ̶decline in nominally fixed incomes (like pensioners) ̶ ̶decline in real interest rates real interest rate (%)= nominal interest rate (%) − the inflation rate (%) (Fisher equation) ̶large price changes create uncertainty, and make it more difficult for households and firms to make decisions based on prices ̶ ̶menu costs (the resources used in setting and changing prices) ̶ ̶shoe leather cost (inflation increases the opportunity cost of holding cash; it is still needed to carry out transaction => more „trips to bank“) ̶ ̶ Adobe Systems Monetary Policy 8 What’s wrong with deflation? ̶when prices are falling, households will postpone consumption (because they expect goods will be cheaper in the future) ̶ ̶redistributing income from debtors to creditors and those on nominally fixed incomes ̶increase in nominally fixed incomes (like pensioners) ̶ ̶increase in real interest rates ̶ ̶ ̶ Adobe Systems Monetary Policy 9 Inflation x deflation ̶a little bit of inflation is a good thing, as long as it remains stable ̶ ̶some amount of inflation gives the central bank more ability to boost the economy ̶ ̶low inflation fosters investment ̶ ̶low inflation helps with downward wage and price rigidities ̶ Adobe Systems Monetary Policy 10 What do central banks do? Central banks: an institution that manages the currency and monetary policy, and oversees their commercial banking system ̶ ̶issue banknotes ̶ ̶provide banks with liquidity ̶ ̶impose compulsory reserves on commercial banks ̶ ̶act as ’lender of last resort’ to banks ̶ Adobe Systems Monetary Policy 11 Liquidity provision ̶to maintain price stability and promote a safe and efficient payment system Liquidity is provided through: ̶open market operations (purchases of financial assets by the CB from commercial banks) ̶ ̶repurchase agreements or repos (short-term agreement between CB and commercial bank under which commercial bank sells a security to the CB and CB provides commercial bank with liquidity; CB holds the corresponding assets for a fixed period) ̶ In so doing central banks set price of liquidity and control the quantity of base money. CB can also influence the banks’ lending behaviour through reserve requirements (the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals). ̶ Adobe Systems Monetary Policy 12 Lender of last resort ̶Commercial banks turn to their lender of last resort (CB) when they cannot get the funding they need for their daily business. ̶ ̶This can happen in periods of financial crisis, when banks may have doubts about lending to each other and lots of people may suddenly want to withdraw their money from their bank account. ̶ ̶CB helps protect people and businesses from the difficulties that can arise when banks are in trouble. Adobe Systems Monetary Policy 13 Central bank credibility ̶CB credibility is very important for effective MP. ̶ ̶How can CB enhance its credibility? ̶By adequate institutional design (independence, transparency and accountability) ̶ ̶By tying its hands: exchange rate peg, monetary policy rules ̶ ̶By selecting conservative central bankers, i.e. more adverse to inflation than the average of society ̶ ̶By incentive contracts ̶ Adobe Systems Monetary Policy 14 Communication ̶communicating relevant information about macroeconomic fundamentals, the condition of financial institutions and the financial sector more generally, and the conduct of policy can reduce uncertainty. ̶ ̶Their communication differs quite a lot ̶ECB Press conference (ECB) ̶ ̶Disclosure of meetings minutes and individual votes ̶ ̶Disclosure of expected interest rate path by Swedish Riskbank, Bank of Norway, Fed ̶ Adobe Systems Monetary Policy 15 Importance of CB independence ̶Why is CB independence so important? ̶independent central bank is insulated from the political pressures ̶ ̶fiscal policy tends to follow a political business cycle, if central banks were subject to political approval, monetary policy would also follow this volatile pattern ̶ ̶elected politicians do not have enough knowledge to conduct monetary policy ̶ ̶If the CB was hold to political interests, the government could accumulate large budget deficits then turn to the CB to pay off its debts Adobe Systems Monetary Policy 16 CB independence ̶Increasing number of countries granted full independence to their CB during 1990s and 2000s. ̶ Adobe Systems Monetary Policy 17 CB independence and inflation ̶This institutional move to independence resulted from the better ability of independent CB to cope with the inflationary pressures Adobe Systems Monetary Policy 18 Central bank independence ̶Consider three measures of CB independence: ̶instrument independence: the central bank is free to set any monetary policy instrument ̶ ̶goal independence: the central bank is free to set its own goals for monetary policy ̶ ̶political independence: the central bank is able to conduct monetary policy without legislative influence ̶ Adobe Systems Monetary Policy 19 Central bank independence Turkey Venezuela Adobe Systems Monetary Policy 20 The objectives of monetary policy The objectives of MP have varied significantly over time: ̶in 70s CB had broad mandates involving difficult trade-offs between alternative targets ̶ ̶after inflation period during 70s price stability emerged as dominant goal ̶ ̶some CBs pursue other objectives simultaneously ̶ ̶after financial crisis 2007-09 discussion about gearing MP more towards financial stability ̶ Adobe Systems Monetary Policy 21 The objectives of MP: price stability ̶Maintain the real value of money ̶ ̶Most central banks aim at keeping inflation rate Inflation should be neither too high: ̶Shoe leather costs, menu costs, redistribution effects, implicit taxation, risk of hyperinflation,.. ̶ ̶Ex: Germany in the 1920s, Argentina in the 80s, Zimbabwe in the 2000s,.. ̶ Adobe Systems Monetary Policy 22 The objectives of MP: price stability •… nor too low – –Risk of deflation and liquidity trap (interest rates are low, saving rates are high => MP is ineffective) – => Most central banks have objectives between 1-3 % ̶ Adobe Systems Monetary Policy 23 The objectives of MP: exchange rate stability ̶Until 90s transition countries relied on a fixed exchange rates as a means of controlling inflation ̶ ̶MP of many European countries focused on maintaining the external value of the currency vis-à-vis some larger country (Austria and Germany) ̶ ̶The attraction of fixed exchange rates has faded away in recent years ̶ ̶Apart from China, only smaller countries (Denmark, some Caribbean countries) continue peg their exchange rate ̶ Adobe Systems Monetary Policy 24 The objectives of MP: output stabilization ̶MP can be used to stabilize aggregate demand, i.e. support demand through an expansionary MP in recession and a restrictive MP when demand is ballooning. ̶ ̶The rationale for counter-cyclical MP goes back to the Great Depression in 1930s. ̶ ̶But desirability and effectiveness of counter-cyclical MP are debated because of time lags which can transform MP into a procyclical policy. ̶ Adobe Systems Monetary Policy 25 The objectives of MP: full employment ̶full employment was one of the leading objectives of the central bank (it was mostly abandoned at the end of the 20th century) ̶ ̶full employment is still a relatively important objective (most central banks would take action if employment starts keeping up) Adobe Systems Monetary Policy 26 The objectives of MP: financial stability ̶Financial stability: proper functioning of banks and financial markets ̶ ̶Usually not a formal objective ̶ ̶Lender of last-resort; CB regulates and controls commercial banks ̶ ̶Responsibility of the CB as a lender of last-resort to banks is inevitable, but should be exerted with great caution because of: ̶Moral hazard problem ̶ ̶Possible incompatibility with price stability ̶ ̶ Adobe Systems Monetary Policy 27 The mandates of four central banks: US Fed ̶Legal vehicle ̶Full Employment and Balanced Growth Act (“Humphrey Hawkins Act”) of 1978 ̶ ̶Objectives: ̶maximum employment (without a fixed goal for employment) ̶ ̶stable prices, meaning low, stable inflation (2 % p. a.) ̶ ̶(financial stability) ̶ ̶ Adobe Systems Monetary Policy 28 The mandates of four central banks: ECB ̶Legal vehicle ̶EU Treaty (since Maastricht Treaty of 1992) Article 127 ̶ ̶Objective ̶maintain price stability (2 % over the medium term) ̶ ̶without prejudice to the objective of price stability, the ECB shall support the general economic policies in the EU with a view to contributing to the achievement of the objectives of the EU ̶ ̶financial stability is not an explicit goal of ECB ̶ ̶ Adobe Systems Monetary Policy 29 The mandates of four central banks: Bank of England ̶Legal vehicle ̶Bank of England Act, 1998 ̶ ̶Objective ̶price stability; definition of price stability belongs to government (2 %) ̶ ̶without prejudice to the objective of price stability, BoE shall support the economic policy of the government, including its objectives for growth and employment ̶ ̶(financial stability) ̶ Adobe Systems Monetary Policy 30 The mandates of four central banks: Bank of Japan ̶Legal vehicle ̶Bank of Japan Law, 1997 ̶ ̶Objectives ̶price stability (inflation 2 % p.a.), thereby contributing to the sound development of the national economy.„ ̶ ̶(financial stability) Adobe Systems Monetary Policy 31 Mandates of CB: key differences ̶US Fed has dual mandate of full employment and price stability, while ECB and BoJ have not ̶ ̶ECB, Fed and BoJ decides on objectives, while BoE do not ̶ ̶Crisis has prompted fresh discussion on the central bank role in financial stability ̶Example: creation in 2011 of European Systemic Risk Board chaired by ECB President ̶ Adobe Systems Monetary Policy 32 Theories Adobe Systems Monetary Policy 33 Theories ̶the short-run nominal rigidities ̶major explanation for the short-run disconnect between monetary growth and inflation is the existence of nominal rigidities ̶ ̶rise in money supply increases the real value of monetary holdings, which affects other real variables (decrease in real interest rate and increase in real consumption) ̶ ̶the short-run impact of MP on real variables relies on incomplete price adjustment Adobe Systems Monetary Policy 34 Standard instruments of monetary policy ̶open market operations (refinancing operations) ̶used for steering interest rates in the economy ̶ ̶executed in the form of repo operations (CB accepts liquidity from banks and in return transfers eligible securities to them as a collateral or CB provides with liquidity to commercial banks) ̶ ̶automatic facilities ̶used for providing and depositing liquidity overnight deposit facility: commercial banks may overnight deposits of surplus liquidity with the CB marginal lending facility: commercial banks may overnight obtain liquidity from the CB ̶minimum reserves ̶every commercial bank is required to hold minimum reserves on its account with the CB ̶ ̶the role is declining Adobe Systems Monetary Policy 35 C.S. Instruments of European Central Bank (ECB) ̶Minimum reserves (1 % of the demand deposits and of time deposits shorter than two years) ̶ ̶Two overnight standing facilities: ̶Marginal lending facility (high rate): -0.50 % ̶ ̶Marginal deposit facility (low rate): 0.25 % ̶ ̶Weekly refinancing operations (competitive bids through which ECB provides liquidity against collateral => refinancing rate (the main rate of Eurosystem): 0 % ̶ ̶These three rates are sometimes called leading interest rates. Interbank rate (EURIBOR) fluctuates between floor and ceiling rate and in normal time close to refinancing rate. ̶ Adobe Systems Monetary Policy 36 Historical ECB rates Adobe Systems Monetary Policy 37 Historical Euribor rates Adobe Systems Monetary Policy 38 Negative interest rates ̶when the economy is in a slump, nominal interest rate of zero may not be low enough to get the economy going again ̶ ̶negative interest rate => banks are more likely to chargé lower interest rates on loans to customers => boost GDP growth and inflation ̶ ̶it can raise financial instability (it can lead to housing or stock market bubble) Adobe Systems Monetary Policy 39 Negative interest rates Adobe Systems Monetary Policy 40 Quantitative easing (QE) ̶aim: to increase aggregate demand by buying assets, even when the policy interest rate is zero ̶ ̶CB buys bonds (both government and corporate) and other financial assets (it creates additional base money) ̶ ÞThis decreases the yield and intrest rate on bonds Þ ÞQE lower the cost of borrowing throught the economy, including for the governement Þ ÞThis boost spending and AD Adobe Systems Monetary Policy 41 Quantitative easing (QE) in UK ̶2009 – Financial crisis ̶ ̶2012 – Eurozone debt crisis ̶ ̶2016 – Brexit referendum result ̶ ̶2020 – Coronavirus pandemic Adobe Systems Monetary Policy 42 Refinancing rates and interbanking market rate in euro area Adobe Systems Monetary Policy 43 Refinancing rates in the US, UK, the euro area and Japan Adobe Systems Monetary Policy 44 Transmission channels of MP ̶Transmission channels: the way monetary policy decisions affect output and inflation ̶ Adobe Systems Monetary Policy 45 The interest rate channel ̶Traditional Keynesian channel: ̶Monetary expansion in the presence of nominal rigidities leads to a fall in the interest rate, hence to a revival of investment and durable-goods consumption and via multiplier affect to rise of aggregate demand (AD) => inflation ̶ ̶Uncertainty: CB can directly affect overnight nominal interest rate, while AD rather depends on expected real long-term interest rates. ̶ Adobe Systems Monetary Policy 46 The asset-price channel ̶Lower interest rate raises asset prices held by households, who in turn partially consume this extra wealth, which then stimulates AD => inflation ̶ ̶The importance of this channel has increased as a consequence of the general rise in the wealth-to-income ratio. ̶ Adobe Systems Monetary Policy 47 The credit channel ̶Lower interest rates stimulate commercial banks to relax credit constraints and hence to stimulate credit supply => AD => inflation ̶ ̶ Adobe Systems Monetary Policy 48 The foreign-exchange channel ̶lower the interest rate, demand for that country’s bonds declines: international investors are less attracted to their financial assets ̶with the demand for bonds lower, the demand for the currency to buy those bonds declines => the decline in demand for the currency will liead to depreciation ̶ ̶lower policy rates stimulate net exports through an exchange-rate depreciation (Mundell-Fleming) ̶ ̶important in small, open economies Adobe Systems Monetary Policy 49 Bank of England transmission mechanism Adobe Systems Monetary Policy 50 Reference textbook ̶Benassy-Quéré, A. et al. Economic Policy: Theory and practise. Oxford University Press, 2010. Chap. 4. Adobe Systems Monetary Policy 51