Macroeconomics: Institutions,
Instability, and the Financial System
These slides are authored by Hillary Wee,
UCL, Cambridge
© Wendy Carlin and David Soskice, 2015. All rights reserved.

Objectives:
Chapter 13: Monetary Policy
 The evolution of CB monetary-targeting to inflation-targeting.
 The modern 𝑀𝑃 framework & modelling how 𝑖 is set.
 Use of Quantitative Easing post-crisis and its possible dangers.
 How conventional 𝑀𝑃 failed in stabilizing financial cycles.
 Remedial actions to this, and an evaluation of these policies : e.g. the effects of increasing bank capital requirements
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

The Nominal Anchor
 Quantity Theory of Money: 𝑷𝒚 = 𝑴𝑽 ( ▲ ); 𝑀 : money supply,
𝑉 : velocity of circulation of money, 𝑃 : price level, 𝑦 : output.
 Log-differentiating ( ▲ ), we get
Δ 𝑃
𝑃
+
Δ 𝑦 𝑦
=
Δ 𝑀
+
𝑀
Δ 𝑉
𝑉
.
 Assuming Δ 𝑦 = 0 and a constant 𝑉 ,
Δ 𝑃
𝑃
=
Δ 𝑀
𝑀
→ π =
Δ 𝑀
𝑀
 From QTM: Money Supply ( 𝑀 ) is a nominal anchor for the economy: growth of 𝑀 fixes the growth of prices (inflation).
 Wages and prices assumed to be perfectly flexible, so economy is always at 𝑀𝑅𝐸 ( 𝑦 = 𝑦 𝑒
).
 Bundesbank successful in using 𝑀 –targeting to stabilize inflation, i.e. establishing χ ≃ 1 for its 𝑃𝐶 constraint: π 𝑡
= [ χ π 𝑇 + 1 −
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

The Nominal Anchor
 Using 𝑀 –targeting to control π requires the CB being able to control a monetary aggregate reliably related to inflation.
 Goodhart’s Law: When the CB chooses a monetary aggregate as a target, the financial system responds by switching to a close substitute outside the target and hence undermines it.
→ Shifts in money demand alter the relationship between money supply and inflation → ∴ Monetary targeting cannot control 𝐴𝐷 predictably.
 Failure in 𝑀 –targeting: Thatcher experiment in disinflation → using
M0 to target M3, but relationship broke down → M0 growth above target, yet disinflation (↓ π , ↑ 𝑈 ) higher than intended.
 𝑀 –targeting to anchor π was flawed → Now, the modern monetary framework uses π 𝑇 to anchor π , and uses 𝑟 to achieve 𝑦 − 𝑦 𝑒
.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Modelling:
Modern 𝑀𝑃 Framework
Modern 𝑴𝑷 framework :
 Active rule-based 𝑀𝑃 : best-response 𝑟 to achieve π 𝑇 (Ch. 3):
 CB min loss, 𝐿 = 𝑦 which yields the 𝑀𝑅 𝑡
:
− 𝑦 𝑒
) 2 + 𝛽 𝜋 𝑡 𝑦
1
− 𝑦 𝑒
− 𝜋
𝑇
) 2
= −αβ π
1 s.t.
𝑃𝐶 , π
1
− π 𝑇 ) .
= π
0
+ α 𝑦
1
− 𝑦 𝑒
) ,
 CB preferences (reflected by 𝛽 ) and responsiveness of π to 𝑦 (ie.
α ) affect the chosen adjustment path ( 𝑀𝑅 ) after a shock.
 (Fig 13.2 a., next slide) β > 1 → Higher importance on π being away from 𝜋
𝑇 than 𝑦 being away from 𝑦 𝑒
→ Larger output (and hence π ) reduction when there is a π shock → Flatter 𝑀𝑅 .
 (Fig 13.2 b., next slide) α ↑ (steeper 𝑃𝐶 ) → π more responsive to 𝑦 → able to cut π by more for a given cut in 𝑦 → Flatter 𝑀𝑅 .
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Modelling:
 𝜷 and/ or 𝜶 higher → 𝑴𝑹 is flatter .
Modern 𝑀𝑃 Framework
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Modelling:
Modern 𝑀𝑃 Framework
 After π shock, econ. at ‘B’; Fig 13.3 a: with steeper 𝑃𝐶 , smaller cut in 𝐴𝐷 is best response (pt.
‘D’ on 𝑀𝑅
1
).
 Fig 13.3 b: Larger cut in 𝐴𝐷 given greater π –aversion.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Modelling:
Modern 𝑀𝑃 Framework
 Sacrifice ratio: The % rise in 𝑈 for a 1% fall in π (cost of disinflation).
 Disinflation strategies: (i) ‘Cold turkey’: achieve faster fall in π but with sharper rise in 𝑈 ; (ii) ‘Gradualism’: 𝑈 rises less, but disinflation process is longer.
 Taylor rule (1993): Rule which well described the Fed’s historical int.
rate behaviour.
𝑇𝑅 : 𝑟
0
− 𝑟
𝑆
= 0.5 π
0
− π 𝑇 + 0.5 𝑦
0
− 𝑦 𝑒
.
 Best response 𝑇𝑅 in our 3 –eqn model: 𝑟
0
− 𝑟
𝑆
=
1 𝒂 α+
1
αβ
)
π
0
− π 𝑇 ) ,
Derivation: Substitute π
1 of the 𝑃𝐶 : π
1
= π
0
+ α 𝑦
1
− 𝑦 𝑒 into the 𝑀𝑅 : 𝑦
1
− 𝑦 𝑒
= −αβ π
1
− π 𝑇 ) , yielding π
0
− π 𝑇 = − α +
1
αβ
) 𝑦
1
− 𝑦 𝑒
.
Then subst. for 𝑦
1
− 𝑦 𝑒 from the 𝐼𝑆 : 𝑦
1
− 𝑦 𝑒
= −𝒂 𝑟
0
− 𝑟
𝑆
.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Modelling:
Modern 𝑀𝑃 Framework
 Optimal 𝑇𝑅 is 𝑟
0
− 𝑟
𝑆
= 0.5 π
0
− π 𝑇 iff. 𝑎 = 𝛼 = 𝛽 = 1 .
 E.g. if inflation is 1% above target, the CB needs to raise nominal int. rate ( 𝑖 ) by 1+0.5% so that 𝑟 = 𝑖 −π can be raised by 0.5%.
 Taylor principle: The need to raise 𝑖 sufficiently to push up 𝑟 , so that the CB’s int. rate response is actually stabilizing.
 Optimal CB response is given by 𝑟
0
− 𝑟
𝑆
=
1 𝒂 𝛼+
1
αβ
π
0
− π 𝑇
, thus:
(i) ↑ β → High π aversion → respond to shock with larger rise in 𝑟 .
(ii) ↑ α → 𝑃𝐶 steeper & 𝑀𝑅 smaller → smaller 𝑟 response to shock.
(iii) ↑ 𝑎 → 𝐼𝑆 flatter (high 𝑟 –sensitivity of 𝐴𝐷 ) → smaller 𝑟 response needed.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
Modern 𝑀𝑃 framework:
Modern 𝑀𝑃 Framework
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
Modern 𝑀𝑃 Framework
 CB affects 𝐴𝐷 using 𝑖 , working through 4 main channels:
1. Market rates: 𝑖 ↓ → Borrowing desirable, saving less → 𝐴𝐷 ↑.
2. Asset prices: 𝑖 ↓ → Asset price ↑ → h/hold wealth ↑→ 𝐶 ↑ (via PIH).
3. Expectations/ confidence: 𝑖 ↓ might show CB commitment to accommodative policy in the future (policy stance) → 𝐴𝐷 ↑.
4. Exchange rate channel: 𝑖 ↓ → 𝑒 ↑ → 𝑄 ↑ → 𝑋 − 𝑀) ↑ → 𝐴𝐷 ↑.
 In reality, CB’s differ by mandates: Dual mandates on π and 𝑦 (US
Fed); price stability as a priority, employment as secondary etc.
 Different CB objectives translated into different int. rate behaviour: e.g. BoE and ECB react more strongly to inflation as opposed to the US Fed (see Castro, 2011).
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
𝑀𝑃 and the global financial crisis (GFC); Chapter 7:
 Dot-com boom (1990s) & Mortgage boom (mid-2000s): CB chose not to ‘prick’ the bubbles, but ‘mop up’ after they burst.
 ‘Mopping up’: Lowering 𝑖 rapidly/ using QE to provide liquidity.
 Asset bubbles are undesirable but CB intervention to burst them depends on:
1. The CB being able to identify bubbles before the financial markets.
2. Refraining from identifying bubbles that do not exist.
3. Bursting bubbles without causing excess damage to the wider econ .
 ‘Greenspan doctrine’: The CB is not able to fulfil these criteria:
CB & mkts have same info. available to them, 𝑖 also unable to pop bubble without harming 𝐶 and 𝐼 not affected by the asset bubble.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
 ‘Mop up after’ strategy worked poorly in the GFC unlike before.
 GFC involved the failure of major banks with high level of interlinkages among them
 CBs previously overlooked systemic risk in the banking system →
Emphasis now on CB role’s in financial stability → CBs today focus on macro-prudential regulation to mitigate systemic risk.
 Unorthodox 𝑀𝑃 was used in the GFC, due to the zero lower bound on 𝑖 and deflationary threats.
 The Taylor rule shows how conventional 𝑀𝑃 ( 𝑖 ) responds to inflation and output shocks, 𝑇𝑅: 𝑖 𝑡
= 𝑖 + γ
1
π 𝑡
− π 𝑇 + γ
2 𝑦 𝑡
− 𝑦 𝑒
 We perform an analysis on implied 𝑖 𝑡 parametric assumptions (p. 485).
given data and certain
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
 For certain periods, the 𝑇𝑅 actually predicts a negative 𝑖 (below).
 This shows that when the ZLB is hit, conventional 𝑀𝑃 is ineffective.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
 Unconventional 𝑀𝑃 : Quantitative Easing (QE).
 5 Transmission mechanisms of QE, as taken from the BoE
Quarterly Bulletin (2011 Q3):
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
 Quantitative Easing (QE) : Buying govt. bonds or mortgage-backed securities from companies to stabilize demand.
 The transmission channels of QE are less clear than that of conventional 𝑀𝑃 . Five transmission channels of QE from Fig 13.6:
1. Confidence: Directly affect asset prices.
2. Policy signaling: QE shows commitment to 𝜋 𝑇
, helping to anchor 𝜋 𝐸 help prevent a deflation trap.
and
3. Portfolio rebalancing: Money from bonds sold to the CB can be used to buy other financial assets, which lowers yield & boosts demand.
4. Market liquidity: Encourages trading and boosts liquidity during distress.
5. Money: More deposits into financial institutions may induce more lending.
 Measuring the impact of QE: Difficult due to absence of counterfactual;
Studies showed fall in gov’t bond yields; QE was equivalent to a 1.5-3% point cut in the CB policy rate (Joyce et. al., 2011).
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
 A concern from QE: Large increase in CB’s total assets.
 Fig 13.7 (below): BoE & Fed assets quadrupled btw. 2006 to 2012;
Not in ECB since no QE executed until more recently.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

In Practice:
𝑴𝑷 and the Financial Crisis
Possible dangers of undertaking QE:
1. CB independence & credibility ↓: Future inflation-targeting becomes harder.
2. Inflation expectations ↑ : QE might lead to higher future inflation, but higher 𝜋 𝐸 was necessary to prevent a deflation trap.
3. Financial cycle: Promotes search for yield, which can inflate asset bubbles.
4. Excess reserves by banks can ↑ loans → inflationary risk.
5. QE Exit: In theory, opposite effect to QE, i.e. downward pressure on π , raise long term yields.
 Reducing QE exit costs: Fed communicated strategies in gradually selling fin. assets. Timing matters: too rapid
→ recovery ↓ ; too long → π risk
↑.
 CB transparency (forward guidance) about the likely path of policy rates may help agents to form more accurate expectations of π and 𝑖 . This may boost confidence on long term int. rates and hence investment.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Post –Crisis :
Financial Regulation
Failures of conventional macro policy framework:
1.
𝜋 - targeting cannot be relied upon to stabilize a financial cycle upswing (Ch.6).
2.
Borrowing & risk-taking above socially optimal level in an upswing.
3.
Ability of 𝑀𝑃 (↓ 𝑖 ) to stimulate borrowing is ill-suited for a post-fin. crisis recession due to ZLB & high preceding indebtedness levels.
4.
Gov’t finances flattered by fin. cycle upswing due to strong tax inflows from housing and financial sectors.
5.
Fin. Crisis worsens fiscal position due to automatic stabilizers, discretionary 𝐹𝑃 and bailing out banks.
6.
Bailing out banks may rapidly increase govt. debt; Also, early austerity can delay recovery.
∴ Focus now on banking system reform to dampen fin. cycles & minimize chances of financial cycles and subsequent crises.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Post –Crisis :
Financial Regulation
Post-crisis reforms:
I) Higher capital ratios
 Rationale: Banks choose higher leverage than socially optimal +
Positive feedback process, which increases leverage & agg. risk.
 Higher capital ratios (i.e. lower leverage) provides a larger cushion against losses & helps avoid taxpayer-funded bailouts.
 Opposition from financial sector: Banks favour debt over equity finance, claiming equity is more expensive
 Modigliani-Miller (MM) theorem: Under certain conditions, cost of finance does not depend on debt- equity mix.
 Is equity more expensive? MM: When equity ↑ → Firm riskiness ↓ →
Required return to equity ↓ → Overall cost of capital does not increase from more equity. (But note, tax systems favour debt).
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Post –Crisis :
Financial Regulation
Two Responses to higher leverage requirements – i. Raising equity; ii. Reducing assets: equity unchanged; reduced debt.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Post –Crisis :
Financial Regulation
 MM for banks: Higher equity requirements reduce risk of bailout → Potential liability to govt.
↓ → Cost of finance to govt. ↓ → But cost of finance for banks ↑.
 Vickers (2012): MM holds when taking both private & public sector together, but not when the private sector is considered in isolation.
 ∴ There exist social costs of higher capital ratios which may offset the social gains from a less risky financial system.
 Miles (2013): Substantial net benefits from higher capital ratios.
 Bulow et. al (2013): Higher capital ratios insufficient to prevent bank failures.
 More problems: Additional equity from higher cap. ratios used to reduce losses to creditors → but shareholders do not see benefit & makes new equity expensive → banks respond to cap. ratios by shrinking assets (Fig 13.8 c.)
 ↑ Cap. Ratios post-crisis is pro-cyclical, inhibits bank lending. Banks may also shift geographically or institutionally to avoid regulation.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Post –Crisis :
Financial Regulation
Post-crisis reforms (contd.):
II) Living wills, resolution schemes, bail-ins.
• Debt conversion to equity or compulsory haircuts imposed on bondholders during near-bankruptcy point.
• Replaces taxpayer-funded bail-outs, but will not remove presumption of rescue by state → ∴ Risky behaviour not necessarily reduced.
III) Structural reform – retail vs investment bank activities
• ↓ Presumption of govt. rescue for retail arm → ↓ risky behaviour in IB arm.
IV) Macro-prudential regulation
• To stabilize the fin. cycle. E.g. decreasing loan-to-value ratios (mortgages)
& increasing capital requirements during financial upswing, and vice versa.
 Bus. cycle stabilization ( 𝑀𝑃 ) may conflict with fin. cycle stabilization (macropru. policy): In recession: 𝑀𝑃 intends to boost 𝐴𝐷 (by ↓ 𝑖 ), but this may fuel a fin. cycle upswing → ∴ Macro-pru policy moves in opposite direction and cuts the loan-to-value ratio. ( ≈ ↑ 𝑖 ).
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Summary:
Chapter 13: Monetary Policy
 𝑀𝑃 evolved from 𝑀 -targeting to π - targeting, where the CB optimizes & sets
𝑀𝑃 based on its preferences over 𝑦 and π .
 The best response 𝑀𝑃 (ie.
𝑀𝑅 ) is affected by π - aversion & the 𝑃𝐶 .
 Higher π - aversion → Flatter 𝑀𝑅 → More aggressive in raising 𝑟 to dampen π , even if 𝑈 ↑ a lot → ‘Cold turkey’, as opposed to ‘gradualism’.
 Best response 𝑟 depends on the π - aversion, 𝑃𝐶 slope and interest-sensitivity of 𝐴𝐷 (i.e.
𝐼𝑆 slope).
 Difficulty in using 𝑀𝑃 to burst asset bubbles → ‘Mop-up’ approach before; But post-crisis, CBs now use macro-prudential policy.
 Quantitative easing helped reduces long run 𝑖 but may have its dangers.
 Conventional 𝑀𝑃 ineffective in stabilizing fin. fluctuations, so governments now resort to capital requirements, structural reforms etc.
 Fin. cycle stabilization might be limited due to conflicts with business cycle stabilization → ∴ Reforming the financial sector is a policy priority.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System