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Theme 5: Macroeconomic policy.
Part 2: Monetary policy
Ragnar Nymoen
University of Oslo, Department of Economics
Introduction
For long periods after the 2 WW monetary policy was relatively passive in many
small open economies. Money demand was accommodated, with no attempt to
control money supply, and with administered low nominal interest rates (regime
I and IV in portfolio model).
GBR and USA represent notable counter examples. Germany, for long time
periods, targeted money supply, in a policy aimed at avoiding inflation (strong
support among the electorate, heritage of hyperinflation between 1. and 2.
WW). In the US, monetary policy has been much more geared towards activity
control (GDP growth, unemployment, inflation) using the short term interest
rate as the instrument.
May 3, 2004
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In the late 1980s and early 1990, several notable developments took place in
Europe, for example:
Organization of lectures
• Financial deregulation and liberalization (housing markets as well)
— removed the basis for direct credit control, essential for the operation
of a “passive monetary” policy.
• Instruments and targets, discussion of concepts
— Made it clear that in the future, monetary policy had to be engineered
“through” the domestic money and bonds markets.
• Traditional monetary policy
• 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.
— Money supply targeting, quantity theory approach
— Money supply targeting in the AD/AS model
• Current monetary policy
• In any case, little room for active fiscal policy in many European countries,
due to government debt and the strict requirements that nations must
meet to become (and stay) members of the monetary union.
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Instruments and targets, an overview
Reading:
Monetary policy: Targets and instruments
B&W ch 20, 20.5 in particular.
Instruments
⇓
OEM ch 3.4 and 10.1
Rødseth: Monetary policy objectives in Norway. In the book Choosing a monetary policy target.
Short-term interest rates, reserve requirements,
market operations, interventions
Intermediate target Indicator with a reliable connection with target
⇓
e.g., money supply, exchange rate, inflation forecast
Target
Inflation, exchange rate.
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Monetary targets are relative to other policy goals
Targets are model dependent
Note that it is not obvious whether for example the rate of foreign exchange is
an intermediate target or a target in itself. It depends on political priorities and
the governing beliefs about how the economy operates. Hence, for example
a fixed exchange rate 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.
In economics, and in central banks, beliefs about how the economy operates
are formalized in models. Hence targets are model dependent.
An intermediate target of monetary policy is defined relative to the target.
Specifically, a (good/useful) intermediate target of monetary policy should be
highly correlated with the target.
Moreover: the targets of monetary policy are in their turn only instruments in
achieving the 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
4. Low unemployment
5. Equity and fair income distribution.
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It is a premise of monetary policy that monetary instruments do not influence
real variables. This view is captured by adopting a vertical long run Phillips
curve in monetary policy model.
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However, flexible inflation targeting include may references to output or employment, cf. Inflation reports and public speeches by Central Bank governors.
The first rationale for money supply targeting is the quantity theory of money,
saying (somewhat loosely) that
This is a concession to the view that over a period of some years, if not in the
long-run, the strive for monetary target attainments cannot be separated from
other (real) targets.
M × velocity = P × Y.
Goes to show that the choice of both targets and instruments are model dependent, in particular dependant upon the government’s (Central Bank’s) view
about how monetary policy affects the economy–the transmission mechanism.
Money supply targeting, the quantity theory approach.
If the velocity of money is constant, and Y is given, and M can be targeted,
then this relationship links the price level, directly to the intermediate target.
A recognized problem with this approach is that the velocity of money is not
constant over time, and its change is difficult to predict. This alone reduces
the quality of M as an intermediate target.
A modernized version of this approach is still with us, and is based on the so
called inversion of the money demand function:
To illustrate how the changing views of the transmission mechanism influence
monetary policy choices, we consider two versions of money supply targeting.
Mt
= L(Yt, it)
Pt
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Taking logs, and differencing with respect to time gives (notation from B&W):
In the 1980s, several countries attempted to control inflation via controlling
the money supply.
πt = µt − ηgt
(8.4)
where µt is the rate of growth of money-supply and gt is the growth rate of Y ,
and η is ElY M/P = LY (Yt, it)Y /L(Yt, it).
However, these policies proved unsatisfactory in practise. Several possible explanation for the failure of money supply targeting
Given that
1. µt can be controlled by the government,
2. η is constant (and known),
1. With a fixed exchange rate it may be difficult to sterilize in order to avoid
endogenous movements in M
2. Even if exogenous, difficult to control (or predict) money supply through
instruments (narrow money and reserve requirements).
3. gt is exogenous and
3. η, need not be constant
4. it is constant,
4. is η a short-run of long-run effect? What about dynamic multipliers?
(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 (wrt M ) from period to period
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and, ultimately:
Money supply targeting in the AD-AS model
The case for the money supply as the target can also be made in the ADAS framework. Domestic market operations represent the instrument (this is
implicit in the following)
πt = µt − ηgt
is a poor model of the transmission mechanism.
In a floating exchange rate regime, the short-run AD curve is shifted rightward
by a monetary expansion.
Formally, from the equation for the float AD curve:
• It involves inversion of causality, i.e., using a demand for money relationship
to determine money P , a procedure which is highly dubious empirically.
• It also assumes that there are no dynamics, and no time lags between a
change in instrument (µt) and inflation.
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
Y = C(Ω̄, Y −T̄ )+I(q̄, i(
dπ
dM
(Iρi M + P CAσ S M σ−1)/P
¯
¯
P
P
> 0.
¯AD,float,short =
−P CAσ σ−1
In the long-run only nominal effects: S & and P %. Long-run elasticities 1%.
In the fixed exchange rate regime there is no shift in the AD schedule.
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Role of capital mobility:
Baseline model assumes perfect capital mobility. If we (instead) assume imperfect capital mobility we have the following modifications:
1. Only minor in float case. Money market analysis as before, and positive
relationship between i and S in the foreign exchange marker (same as the
downward sloping “Ei-curve” in the OEM model).
2. In a fixed exchange rate regime sterilization 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
The AD-AS model, which is a much better model of the transmission mechanism than the quantity theory, re-installs money supply targeting as a possible
operational target for monetary policy.
However, the M instrument affects target variables π and Y via the interest
rate. Hence, why not use the interest rate as the instrument, since this entails
reducing the “distance” between instrument and target? Good for transparency
and goal attainment. This is the approach taken in modern monetary policy.
M
, Y ), i M ≤ 0, iY ≥ 0.
P
P
In that case i & also in this regime induces a positive vertical shift in the
AD curve. Difficult to say in which regime the short-run increase in Y is
largest.
i = i(
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