Institutions of Macroeconomic Policy
Jeffrey Frankel
Harpel Professor
Spring 2012 Advanced Workshop on Global Political Economy,
Institute for Global Law & Policy, Harvard Law School
Lecture I, May 30
Monetary Policy Institutions:
Central Banking
Institutions
•
Economists have begun to pay more attention to “Institutions”
–
–
In such areas as Macroeconomics, Development Economics,
and Economic History: Douglass North (1991) on property rights.
•
Example (“Lucas Paradox”):
Why does capital often flow “uphill”: to countries that
already have a lot of capital, rather than to those without?
Answer: Because the former group are the countries that
have institutions, such as rule of law, that assure investors
they will be able to reap the returns on their investments.
•
But we need to get more specific
about what sorts of institutions work.
•
These 3 lectures will look at institutions in the areas of monetary
and fiscal policy, with an application to the current euro crisis.
Central Banking
The three big objectives of central banks:
•
(1) Price stability
•
•
(2) Financial stability
•
•
avoiding inflation.
avoiding banking panics
and financial crashes.
(3) Economic stability
•
avoiding recessions.
(1) Stable money
•
Objective:
To supply a currency that can be used
throughout the country and that will keep
its value, i.e., will not be inflated away.
•
In the 19th century, the gold standard
was the original institution to guarantee
(long-run) price stability.
–
–
UK (from 1821)
US (from 1873)
(2) Financial stability
Objective: To act as a Lender of Last Resort
in the face of potential bank runs
or other financial panics.
•
UK -- Bagehot’s rule (1873):
In a panic, the central bank should be prepared
to lend unlimited amounts to banks
–
provided their problem
is a liquidity shortage,
rather than insolvency,
–
against collateral.
The famous bank run
in It’s a Wonderful Life
The bank run in Mary Poppins
Financial stability, continued
• US –
– American antipathy to eastern banking elites defeated
19th-century attempts to found
a national bank.
– In the Panic of 1907, J.P. Morgan
had to act as Lender of Last Resort.
– => At Jekyll Island (1910), six conspirators
secretly drafted Aldrich Plan for a central bank.
• Congress passed the Federal Reserve Act in 1913
• with anti-elite protections,
– incl. 12 Federal Reserve districts.
A true bank run, NYC, ≈ 1931
American Union Bank
•
US, continued
–
Response to banking collapse in Depression
•
FDR called national bank holiday,
after which only those banks
judged to be solvent
were allowed to re-open (1933).
•
Financial reform to reduce future moral hazard -The Banking Act of 1933:
–
–
–
FDIC
» Insurance of deposits (up to $10K)
Matched by requirements that banks hold reserves & capital.
“Glass Steagall”
» Commercial banks,
who benefit from safety net,
could not also engage in
risky investment banking.
•
But the “financial stability” goal of central
banking had been largely forgotten by the end
of the century (or taken for granted)
–
•
with the exception of emerging market crises.
Lesson that monetary theory should take
from the 2007-09 global financial crisis:
–
excessive monetary ease
can show up in the form
of asset price “bubbles”
•
–
and not necessarily always in the form of inflation
•
–
leading to crashes & recessions,
leading to crashes & recessions.
Von Hayek, Minsky,
Kindleberger.
Monetary ease in 2003-05 was excessive
(at least in retrospect)
Source: Benn Steil, CFR, March 2009
US real interest rate < 0
(3) Final central banking objective:
Stabilize the real economy
•
In response to unemployment and
lost real GDP in the Great Depression,
federal policy was given responsibility
for stabilizing economic activity.
•
•
as codified in Employment Act of 1946
and Humphrey-Hawkins Act of 1978,
•
including dual mandate for Fed:
low inflation (“price stability”) &
low unemployment (goal = 4%).
•
Monetary policy mistakes in the interwar years
(arising in part from mistaken belief that wages & prices
would adjust rapidly to clear labor & goods markets)
had had huge costs:
•
UK (1925) returned to gold standard
at overvalued exchange rate
(despite warnings from Keynes in
On the Economic Consequences of Mr. Churchill.)
•
US allowed M2 money supply to decline after 1929
(as documented by Milton Friedman & Anna Schwartz,
in A Monetary History of the US).
•
Premature renewed US monetary (& fiscal) contraction
brought back recession in 1937-38,
–
a mistake we are all in danger of repeating today.
The Fed let M1 fall after 1929,
but was careful not to repeat the mistake after 2007.
2008-09
1930s
Source: IMF, WEO, April 2009, Box 3.1
•
Monetary (and fiscal) expansion in 1960s was
heyday of “Keynesian” policy to stimulate growth.
•
Re-thinking then followed,
due to ever-rising inflation
–
and also due to another consequence of excessive
expansion: widening US balance of payments deficit
•
which accelerated the end of the Bretton Woods system
(ending in 1971 $ devaluation & 1973 floating).
peak:
early 80s
Copyright 2007 Jeffrey Frankel, unless otherwise noted
peak:
≈ 1990
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
peak:
early 90s
The formal retreat from activist monetary policy
•
The Phillips curve (1958) had implied that monetary
policy could push up employment and output
indefinitely, at the cost only of steady inflation
–
Samuelson, Solow,
•
•
both of whom are Nobel Prize winners.
It was superceded by the Natural Rate Hypothesis:
if unemployment were held below its natural rate,
inflation would accelerate without limit
–
Friedman and Phelps (1968), another 2 Nobel Prizes.
The retreat from activist monetary policy, continued
• The Natural Rate Hypothesis was followed
by the Rational Expectations Hypothesis:
– Any systematic pattern of monetary policy
(e.g., expansion in recessions or election years)
would be built into expectations.
– Only random monetary changes can have real effects,
because only they are unexpected.
=> Discretionary monetary policy not useful.
– Lucas, Sargent, Barro in mid-1970s.
2 / 3 Nobel Prizes.
• Implication: Discretionary monetary policy is not useful.
The
Mexican
sexenio
From 1976
through 1994,
inflation would
should up and
the peso would
devalue, every 6th
year (presidential
election years).
•
Then came the Dynamic Consistency Hypothesis:
When central banks have discretion,
equilibrium entails an inflationary bias.
–
–
They have to print money even just to match
the inflation that the public expects,
with no growth benefits.
–
Kydland & Prescott, and Barro. 2 / 3 Nobel Prizes.
•
Implication:
Monetary authorities might as well give up
on trying to stabilize the real economy.
Instead, commit credibly to low inflation.
–
=> expectations of low inflation
=> attain actual low inflation without having
to suffer unemployment or lost output to do it.
Addressing the time-inconsistency problem
 How can the Central Bank credibly commit
to a low-inflation monetary policy?
 Announcing a policy target π = 0 is time-inconsistent,
because a CB with discretion will inflate ex post,
and everyone knows this ex ante.

CB can eliminate inflationary bias
only by establishing non-inflationary credibility,

which requires abandoning the option of discretion.

so public will see the CB can’t inflate even if it wants to.

CB “ties its hands,” as Odysseus did in the Greek myth.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
If monetary policy cannot have a systematic effect on output anyway,
the central bank
might as well
give up,
and attain the
only goal it can:
price stability.
But only if it
“ties its hands” will its commitment not to inflate be credible.
Addressing the time-inconsistency problem
 1) Delegation.
Appoint a central banker with high weight on low inflation,
and grant political independence.
Rogoff (1985):
 2) Reputation
 3) Binding rules.
1. Price of gold
2. Money growth
3. Exchange rate
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Commit to rule for a nominal anchor:
4. Price level
5. Nominal GDP
6. Inflation rate
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Addressing the time-inconsistency problem (continued)
1) Delegation
• Legal independence:
– Governors have long terms and can’t be fired.
– Central bank has its own budget.
– No obligation to buy government bonds,
• “monetization of the debt”,
• either directly nor indirectly.
• The original independent central banks:
– Federal Reserve, Bundesbank & Swiss National Bank.
• In the 1990s,
– independence was also granted the Bank of England,
Bank of Japan, & many others (Korea, Mexico, …)
– The ECB was given complete independence.
• Delegation
Alesina & Summers: Central banks
that are institutionally independent
of their governments have lower
inflation rates on average.
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API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Transition
economies
Copyright 2007 Jeffrey Frankel, unless otherwise noted
“Central Bank Independence, Inflation and Growth in Transition Economies,”
P.Loungani & N.Sheets, IFDPS95-519 (1995)
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Limitations to the argument
for central bank independence
1. Some consider it undemocratic.
2. The argument only works if
conservative central bankers are chosen.
3. Although independence measures are inversely correlated with
inflation, these measures have been debated and,
4. more importantly, the choice to grant independence could be
the result of priority on reducing inflation.
5. As with rules to address time-inconsistency,
there is little empirical evidence that it succeeds
in reducing inflation without loss of output.
6. As with rules, one loses ability to respond to short run shocks.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Addressing the time-inconsistency problem (continued)
2) Reputations
• A new Central Banker can act tough
in early periods, to build a reputation
for monetary discipline,
– and can then ease up subsequently
• without reigniting inflationary expectations.
– US examples: Volcker, Greenspan.
– Might explain
why the ECB
takes a hard line.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
3) Rules
Fashions in choice of nominal anchor
• 1980-1982: Monetarism
(target the money supply)
• 1984-1998: Fixed exchange rates
(incl. currency boards & monetary union)
• 1999-2008: Inflation Targeting
(target some version of the CPI)
Professor Jeffrey Frankel
6 proposed nominal targets and the Achilles heel of each:
Monetarist rule
Inflation targeting
Nominal income
targeting
Gold standard
Commodity
standard
Fixed
exchange rate
Targeted
variable
Vulnerability
Example
M1
Velocity shocks
US 1982
CPI
Import price
shocks
Oil shocks of
1973-80, 2000-08
Measurement
problems
Less developed
countries
Nominal
GDP
Price
of gold
Price of agric.
& mineral
basket
$
(or €)
Vagaries of world
1849 boom;
gold market
1873-96 bust
Shocks in
Oil shocks of
imported
1973-80, 2000-08
commodity
Appreciation of $
1995-2001
(or € )
Professor Jeffrey Frankel
The exchange rate anchor
• Many small or developing countries that had
very high inflation rates finally achieved price stability
in the 1990s by means of new exchange rate targets.
• Increasingly popular were legal/institutional means
of committing credibly to a fixed exchange rate:
– Currency boards (Hong Kong, Argentina, Bulgaria, Baltics…)
– Dollarization (Ecuador, El Salvador, Montenegro…)
– Monetary Unions (particularly European Monetar y Union in 1999);
• especially after weaker exchange rate targets
failed in the currency crises of 1997-98:
– Band/Basket/Crawl (Mexico, Thailand, Korea, Indonesia, Russia, Turkey).
– But most responded by moving to the opposite corner: floating.
Inflation Targeting originated in New Zealand in 1990.
Spread to northern countries and, starting in 1999, to EM countries.
Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer. Online at: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Countries adopting IT experienced lower inflation
Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Inflation Targeting has taken some heavy blows recently
• The biggest setback came in Sept. 2008:
central banks that had relied on IT
had not paid enough attention to asset bubbles.
– Central bankers had thought they were giving asset markets all the
attention they deserved: housing & equity prices could be taken into
account to the extent they carried information regarding inflation.
– But this escape clause proved insufficient:
– When the global financial crisis hit -- suggesting at least in retrospect
that monetary policy had been too loose during the years 2003-06 --
it was neither preceded nor followed by an upsurge in inflation.
• The same thing had happened when asset markets crashed in
the US in 1929, Japan in 1991, and Thailand & Korea in 1997.
• Also, the Greenspan reliance on monetary easing to clean up
the mess in the aftermath of such a crash proved wrong.
Another major drawback of IT:
inappropriate response to supply shocks & trade shocks.
• Monetary policy should respond to an increase in world
prices of export commodities by tightening enough
to appreciate the currency (“accommodating the terms of trade”).
• But CPI targeting instead tells the central bank to
appreciate in response to an increase in the world price
of import commodities -- exactly the opposite of
accommodating the adverse shift in the terms of trade.
– E.g., it is suspected that the reason for the otherwise-puzzling
decision of the ECB to raise interest rates in July 2008
-- as the world was sliding into the Great Recession -was that oil prices were reaching an all-time high.
– Oil prices get a substantial weight in the CPI, so stabilizing
the CPI when $ oil prices go up requires appreciating versus the $.
End of Lecture I
Monetary Policy Institutions: Central Banking
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
http://ksghome.harvard.edu/~jfrankel/
Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/
Appendix 1: Dynamic inconsistency
• Assume governments, if operating under discretion,
choose monetary policy and hence AD
so as to maximize a social function of Y & π.
– => Economy is at tangency of AS curve &
one of the social function’s indifference curves.
– Assume also that the social function centers on Yˆ > Y ,
even though this point is unattainable, at least in the long run.

• Assume W & P setters have rational expectations
– => πe (&  AS) shifts up if rationally-expected E π shifts up
– => πe = E π
=
π on average.
•
•
 economy is at point B on average. Inflationary bias: πe=E π > 0.
• Lesson: The authorities can’t raise Y anyway,
so they might as well concentrate on price stability at point C.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
3. But πe adjusts
upward in response
to observed π>0.
The LR or Rational
Expectations
equilibrium must
feature πe = π.
π
πe
●
Result: inflationary
bias π>0, despite
failure to raise Y
2. If πe would stay
at 0,
then to get the
higher Y
it would be
worth paying the price
of π>0.
●
above Y .
4. The country
would be better off
“tying the hands”
of the central bank.
Result: Y = Y
(no worse on average
●
Yˆ
than under discretion),
and yet π=0.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
1. Barro-Gordon
innovation:
It can be useful to
think of society’s
1st choice for
output as Y= Yˆ
(& π=0), even if it
is unattainable.
Time inconsistency of non-inflationary monetary policy, continued
y  y   (   )
e
+ Policy-maker minimizes quadratic loss function:
1
1
2
2
  ( y  yˆ )  a( )
2
2
,
where the target
=>
yˆ  y
1
1
e
2
2
ˆ
  ( y   (   )  y )  a ( )
2
2
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
.
Given discretion, the CB chooses the rate of money growth and
inflation π (assuming it can hit it) where
d
e
 ( y   (   )  yˆ )  a( )  0
d
Take the mathematical expectation:
( y  E (   )  yˆ )  aE ( )  0.
e
+ Rational expectations:
E 

Copyright 2007 Jeffrey Frankel, unless otherwise noted
a
  E
e
( yˆ  y )  0
=>
the inflationary bias.
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
.
Appendix 2: Seignorage
is another reason for inflation, including hyperinflation
How do governments finance spending?
• Taxes
• Borrowing
• Domestic
• Abroad
• Seignorage ≡ creating money to finance deficits
(Inflation tax ≡ money creation in excess of
rising money demand from real growth.)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Hyperinflation in Zimbabwe
The world’s
most recent
hyperinflation:
Zimbabwe,
2007-08
Inflation peaked at
2,600% per month.
The driving
force?
Increase in
money supply:
The central bank
monetized
government debt.
The exchange rate
increased
along with
the price level.
Both increased far
more than the money
supply.
Why?
When the ongoing
inflation rate is high,
the demand for money
is low, in response.
For M/P to fall,
P must go up
more than M.
The real economy plummeted in 2008