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Theme 5: Macroeconomic policy.
Part 2: Monetary policy (I)
Introduction
Long periods after WWII with relatively passive monetary policy in many open
economies. Money demand was accommodated in order to achieve low nominal
interest rates (regime I and IV in portfolio model).
Notable counter examples:
Øystein Børsum
Temporary lecturer, University of Oslo
• Germany: Targeted money supply for long periods. Policy aimed at avoiding inflation
• US: Monetary policy much more geared towards activity control (GDP
growth, unemployment, inflation). Short-term interest rate as instrument.
April 18, 2005
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Notable developments in Europe in the late 1980s and early 1990:
• Financial deregulation and liberalisation (including housing markets)
— Removed the basis for direct credit control, essential for the operation
of a ”passive” monetary policy.
— Implied that monetary policy had to be operated through the domestic
money and bonds markets.
• Financial innovation and deregulation: Added to the difficulties of money
supply targeting.
• Reduced belief in the possibility of detailed demand management by means
of fiscal policy.
• Reduced room for active fiscal policy in many countries. High government
debt and strict requirements to become members of the monetary union.
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Lecture (I):
• Instruments and targets, discussion of concepts
• Traditional monetary policy
— Money supply targeting: The quantity theory approach
— Money supply targeting in the AS-AD model
Lecture (II) and (III):
• Modern monetary policy
Lecture (IV):
• Inflation forecasting
• Summing up the course
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Instruments and targets, an overview
Reading:
Monetary policy: Targets, intermediate targets and instruments
B&W ch 20
Instruments
⇓
OEM ch 3.4 and 10.1
Rødseth: Monetary policy objectives in Norway. In the book Choosing a monetary policy target.
Means by which monetary policy is operated:
Short-term interest rates, reserve requirements,
market operations, FX market interventions
Intermediate target Indicator with a reliable connection with target:
⇓
Ex: money supply, exchange rate, inflation forecast
Target
End goal of monetary policy:
Inflation, exchange rate, output stability
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Intermediate targets vs. targets
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Monetary targets relative to other policy goals
An intermediate target of monetary policy is defined relative to the target. A
good or useful intermediate target should be highly correlated with the target.
Note: May not be obvious whether the exchange rate is an intermediate target
or a target (i.e. a goal in itself). Depends on political priorities and belieft about
how the economy operates that are not always transparent. Ex: Norges Bank
2004: Exchange rate movements important because of pass-through effects to
import prices.
Targets are model dependent
Targets of monetary policy are in turn perceived as instruments in achieving
goals of economic policy with higher priority, such as
1. High private consumption
2. Provision of public goods, in sufficient quantity and quality
3. Securing the conditions for economic growth
The central banks’ beliefs about how the economy operates are formalised in
models: Targets become model dependent. Ex: Exchange rate target may be
given up because of a lack of belief in the possibility of reaching the target,
or because an alternative target like low and stable inflation is believed to give
higher economic welfare over time.
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4. Low unemployment
5. Equity and fair income distribution
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Money supply targeting: The quantity theory approach.
Quantity theory of money: The quantity of money determines the value of
money.
Fisher equation:
A modernised version of this approach is based on inverting the money demand
function:
Mt
= L(Yt, it)
Pt
M × V = P × T.
Assume i trendless (constant), take logs and differentiate with respect to time
to obtain (notation from B&W):
V = velocity of money, T = number of transactions in the economy. Interpretation: The quantity of money spent equals the quantity of money used.
πt = µt − ηgt
Suppose that V and T are constant: Links M to the price level. Increases in
the supply of money are the main causes of inflation. Target M to control
inflation: Foundation stone of monetarism. Friedman: ”Inflation is always and
everywhere a monetary phenomenon”.
where µt is the growth rate of money supply, gt is the growth rate of Y ,
and η is the elasticity of money demand with respect to Y: ElY M/P =
LY (Yt, it)Y /L(Yt, it).
(8.4)
When V is not constant over time, and changes are difficult to predict, M will
be a faulty intermediate target for P .
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1980s: Several countries attempted to control inflation via controlling the
money supply, but this proved unsatisfactory in practice.
Possible explanation for the failure of money supply targeting:
Given that
1. µt can be controlled by the government,
1. With a fixed exchange rate: Difficult to sterilise sufficiently to avoid endogenous movements in M
2. η is constant (and known),
3. gt is exogenous and
2. Even if M is exogenous: Difficult to control and predict money supply
through instruments (M0 and rr)
4. it is trendless (constant),
3. η may not be constant, and may be different in the short and the long run
4. Time lags between a change in the growth rate of money µt and inflation
πt = µt − ηgt
(8.4)
provides a rationale for choosing the growth rate of money supply as the intermediate target and the rate of inflation as the ultimate target.
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5. gt not exogenous but dependent on M from period to period
Conclusion: Although hard to refute as a rational long run relationship,
the quantity theory of money-approach has had limited success as a shortterm policy guidance. Specifically: Need to be more specific about the
transmission mechanism, i.e. how monetary policy affects the economy in
the short run.
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Money supply targeting in the AS-AD model
The case for the money supply as the target can also be made in the ASAD framework. Assume perfect capital mobility. Domestic market operations
represent the instrument by which M is set.
Floating exchange rate regime: The short-run AD curve is shifted rightwards
by a monetary expansion dM > 0
In the long-run only nominal effects: S & and P %. Long-run elasticities 1%.
Fixed exchange rate regime and perfect capital mobility: No independent monetary policy.
Recall the short-run AD curve:
Y = C(Ω̄, Y −T̄ )+I(q̄, i(
M
M
, Y )−π̄)+Ḡ+P CA(Y, Y ∗, (S(i∗, , Y )/S−1+π−π ∗)σ−1)
P
P
the vertical shift is given by
σ
(Ir i M + P CAσ S M S−1 )/P
dπ ¯¯
P
P −1
> 0.
¯AD,float,short =
dM
−P CAσ σ−1
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Baseline model assumes perfect capital mobility. Modifications with imperfect
capital mobility:
Conclusion: The AS-AD model provides a rationale to control money supply.
The AS-AD model includes an explicit description of the transmission mechanisms.
Role of capital mobility:
1. Only minor in float case: Regular money market analysis. Still positive
relationship between i and S in the FX market (cf. Ei-curve in the OEM
model)
2. In the fixed exchange rate regime (full) sterilisation is now possible: i is
determined in the domestic market. Hence, we can think in terms of a
functional relationship between monetary stance and interest rate similar
to
M
i = i( , Y ), i M ≤ 0, iY ≥ 0.
P
P
i & induces a positive vertical shift in the AD curve.
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However: M affects target variables π and Y via the interest rate. Why
not use the interest rate as the instrument, instead of money supply? This
entails reducing the “distance” between the instrument and the target. Good
for transparency and goal attainment. This is the approach taken in modern
monetary policy.
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