CENTRAL BANKS AND
MONETARY POLICY
STRATEGY
( Chap. 14; Chap 17, 434-444…454-457)
2
Principles of Monetary Policy Strategy
Pt. I.
Why Price Stability?
1.
2.
3.
4.
There is no long-run tradeoff between
unemployment and inflation.
Price stability has important benefits.
Inflation is always and everywhere a
monetary phenomenon.
A strong nominal anchor is the key to
producing good monetary policy outcomes.
Mishkin, Monetary Policy Strategy After the Crisis
Expectations, Policy Credibility, and Transparency
2
1. No Long Run Tradeoff: The
Phillips Curve
• Overall goal of government economic policy is to
increase wealth in the economy
• High Real Economic Growth
• High Employment Levels
• Economic Consensus: Central banks cannot
directly impact long-run real growth on the basis
of decision to produce more (or fewer) bank
notes but they can affect real output &
employment in the short-run.
4
World Development Indicators
Outline
5
2. Benefits of Price Stability
• High inflation leads to
• Increased transactions costs
• Tax on Cash Holdings
• Distortions of economic decisions
• Uncertainty
• Over-investment in financial sector
3. Inflation is Always a Monetary
Phenomena
• Trite at some level. Inflation is growth rate of prices.
Prices are measured in money. QED.
• Relevant Meaning – Monetary authorities own inflation.
• Central Banks are monetary authorities in modern
economies.
• Central Bank:
Economy
Central Bank
A special
governmental
organization or
quasigovernmental
institution within the
financial system
that controls the
medium of
exchange.
HK
Hong Kong
Monetary Authority
USA
Federal Reserve
EU
European
Central Bank
People’s Bank of
China
Bank of ….
PRC
UK,
Canada,
Japan,
Korea
What is a central bank?
• Central banks have two main roles:
• Banker to the government
• Manage many financial assets of the government.
• Monopoly on the issue of banknotes/currency (true
almost everywhere, but not HK)
• Arm of government policymaking
• Banker to commercial banks.
• Operate the Payment System
• Regulate Banking System
• Lender of Last Resort during a crisis
Powers & Purpose
• Unlike private sector banks which maximize
profits, the central bank attempts to
increase wealth of the entire society.
• Main powers of central bank:
• Deciding the quantity of the monetary base
• Use this power to set short-term interest rates (?)
• In some economies, including HK, will regulate
the banking system.
Focus on Stability
• Central banks can have much more impact by
stabilizing the economy in the short-run (which may
have indirect positive impact on growth).
• But the central goal of most central banks is to
maintain a stable price level meaning low inflation.
Why?
• Making an effort to keep inflation low overcomes key flaw
of paper money or fiat money, its unlimited supply.
Policy Framework
• Fed Objective Humphrey Hawkins Act (1978): Fed
instructed by Congress to be “conducting the nation's
monetary policy .. in pursuit of maximum employment,
stable prices, and moderate long-term interest rates “
• ECB Objective “The primary objective of the ECB’s
monetary policy is to maintain price stability. The ECB
aims at inflation rates of below, but close to, 2% over the
medium term.”
• Japan Objective: Bank of Japan Act Article 2 Currency
and monetary control by the Bank of Japan shall be
aimed at achieving price stability, thereby contributing to
the sound development of the national economy
12
Genberg, H and D He (2009): “Monetary and financial cooperation among central banks
in East Asia and the Pacific”, in R Rajan, S Thangavelu and R Parinduri (eds), Exchange
Rate, Monetary and Financial Issues and Policies in Asia, World Scientific Publishing Co,
pp 247 – 70
13
More Goals
Mongolia
Price stability and
exchange rate stability
Sri Lanka
Economic and price
stability
Nepal
Price and Balance of
payments stability
“The main objective of Bank of Mongolia is to sustain
stability of national currency tugrug” and this statement can
be interpreted in two manners. For instance, stability of
tugrug in the external market refers to the stability of
exchange rate of tugrug in foreign currencies, whereas
stability of tugrug in domestic market refers to the stability
of Consumer Price Index.
One of the core objectives of the Central Bank of Sri Lanka
is economic and price stability… Economic and price
stability is a situation where there are no wide fluctuations
in the general price level in an economy which helps to
achieve sustainable economic growth.
Key objectives of the Bank are to achieve price and balance
of payments stability, manage liquidity and ensure financial
stability, develop a sound payments system, and promote
financial services.
Afghanistan Price Stability
As enshrined in DAB law (Article 2, Para.1), the primary
objective of DAB is to achieve and to maintain domestic
price stability
Brunei
Exchange Rate
Stability
Myanmar
Macroeconomic
Stability
Cambodia
Price Stability
The country’s monetary discipline of having a
currency board system has ensured the full
convertibility of base money with the exchange rate
pegged at par to the Singapore Dollar.
The main objective of monetary policy in Myanmar
is to maintain macroeconomic stability in the
economy while promoting domestic savings.
determine and direct the monetary policy aimed at
maintaining price stability".
14
4. A strong nominal anchor
The Wage Price Spiral
• “Thirty years ago, the public's expectations of
inflation were not well anchored. With little
confidence that the Fed would keep inflation low and
stable, the public at that time reacted to the oil price
increases by anticipating that inflation would rise still
further. A destabilizing wage-price spiral ensued as
firms and workers competed to "keep up" with
inflation. … The episode highlights the crucial
importance of keeping inflation expectations low and
stable, which can be done only if inflation itself is low
and stable.” Bernanke, 2006
Expectations, Policy Credibility, and Transparency
14
15
The importance of the nominal anchor.
• If workers expect high inflation they will demand
high wage growth. But if firms experience growth
in labor costs, they will price in high inflation. A
self-fulfilling prophecy!
• Only if central bank displays a strong
commitment to low and stable inflation, will
expectations be anchored toward low and stable
inflation.
Expectations, Policy Credibility, and Transparency
15
16
Quantitative Anchors
• Monetary Targets – Growth in monetary
aggregates
• Exchange Rate Targets
• Inflation Targets
Fatas, Mihov, and Rose (2006) find that countries with
explicit targets have less inflation. They find that meeting
pre-announced numerical targets leads to an improvement
in macroeconomic outcomes; this matters more than the
nature of the regime
17
What is Inflation Targeting?
• An increasingly popular choice of monetary policy
framework first adopted in New Zealand in 1989.
• Many inflation targeting countries have
successfully lowered inflation and inflation
expectations.
• WEO (2005) presents an optimistic view.
• Gürkaynak, Levin, and Swanson (2006) show long-
term inflation expectations are more stable under
inflation targeting indicating better anchoring.
18
19
List of
Inflation
Targeting
Countries
Rose, 2006
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
Outline
New IT
• Italics indicate possible
non-FFIT.
• Reference: IMF
Working Paper; Bank
of England Handbook;
Various central banks.
Country
Georgia
Dom. Rep.
Paraguay
Albania
Armenia
Ghana
Guatemala
Moldova
Serbia
Uruguay
Japan
Adoption Date
2009
2012
2011
2009
2006
2007
2004
2010
2009
2007
2013
INFLATION TARGETING
22
Characteristics
1.
2.
3.
4.
5.
An explicit central bank mandate to pursue
price stability as the primary objective of
monetary policy,
Explicit quantitative targets for inflation;
Policy actions based on a forward-looking
assessment of inflation pressures, taking into
account a wide array of information;
Increased transparency of monetary policy
strategy and implementation.
Mechanisms of accountability for
performance in achieving the objective;
Laxton and Freedman, 2009, Why Inflation Targeting
23
1. Commitment to Price stability as primary goal
• Central Bank has commitment to achieve low and
stable inflation in the short-run and in the long-run
“Like most other central banks, the Bank of Korea
takes price stability as the most important objective of
its monetary policy. The current Bank of Korea Act
clearly sets out price stability as the purpose of the
Bank of Korea's establishment and stipulates that it
should seek to bring about price stability by setting an
inflation target in consultation with the government and
do its utmost to attain this target.”
BACK
2. Medium term numerical targets for
inflation.
Public announcement of specific inflation rate goal (w/
room for error) over specific term or period.
• Based on Article 6, Clause 1 of
the 「Bank of Korea Act」, the
Numerical goal subject to change
Bank of Korea sets the mid-term
inflation target to be applied for
three years in consultation
with the government. The
inflation target measure during
the period from 2013 to 2015 is
set at 2.5~3.5%, based
on consumer price
inflation (year-on-year).
BACK
24
25
3. Policy actions based on a forward-looking
assessment of inflation pressures
• Forward looking operating procedure – monetary
instruments operate only with some lag. Targeting
medium term inflation means setting today’s
policy for tomorrow’s economy.
• Must inevitably target the forecast.
The Bank reduced the Base Rate that had been held at 2.75% a year since
November 2012 by 0.25 of a percentage point in May this year against the
background in which not only there were large downside risks to growth owing to
the slow pace of the world economic recovery,…, but also inflation pressures were
expected to stay at a moderate level for some time to come due to the unexpected
stability of oil and agricultural product prices. LINK
26
Back
Garcia-Herrero and Remolena,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457506
Inflation Reports
• Central bank publishes
its inflation forecast with
probability distributions
to indicated degree of
uncertainty.
BACK
27
28
4. Transparency
1.
2.
3.
4.
Learning about policymakers’ plans can cause shifts in
expectations
The more unstable are market expectations, the greater will
be the instability in macroeconomic performance
Keeping agents’ expectations aligned with policymakers’
plans helps avoid big surprises
Credible central bank communications has calming impact
on agents’ expectations
This approach stands in sharp contrast to
previous central banking practice.
29
4 Things for the Central Bank to
Communicate About
Goals and Instruments
i.
Fun Fact: Until 1994, U.S. Fed did not reveal policy instrument was
Fed Funds Rate
ii. Policy Decisions and their Basis
•
Policy Statements & Meeting Minutes
iii. Economic Forecasts
iv. Monetary Policy Outlook
•
Specific or suggestive
30
5. Mechanisms of Accountability
• Under IT, central bank retains instrument
independence but must thereby retain
responsibility for achieving objectives.
• Many IT regimes include an accountability
mechanism.
Mechanisms
Open Letter to the President
To ensure accountability in cases where the
BSP fails to achieve the inflation target,
the BSP Governor issues an Open Letter
to the President outlining the reasons
why actual inflation did not fall within
the target, along with the steps that will
be taken to bring inflation towards the
target. Open Letters to the President
have been issued on 16 January
2004, 18 January 2005, 25 January
2006, 19 January 2007, 14 January
2008 and 26 January 2009.For 2010,
the BSP met the target and no open letter
was issued.
Bank of England Handbook
32
What measure of Inflation should be used?
Headline Consumer Price Index
• ‘Core’ versus
‘headline’ CPI
• Headline CPI ~ Index of All Consumer Goods
• Core Inflation ~ Index of Consumer Goods less volatile
price goods (i.e. food and energy).
• Tradeoffs
• ‘core’ more stable and better predictor of future inflation
• Food and Energy large share of emerging market consumer
baskets and hard for public to ignore.
Back
Targeters and
their
Targets
Bank of England Handbook
34
Over what horizon should inflation be measured?
• Usually over a range of 1 year at the shortest to 3
years at the outside.
• Keeping inflation near target even in the short-run offers
greater credibility…if it can be accomplished.
Short-term programs often adopted for disinflation.
• Longer term targets allow the economy more flexibility to
adjust to temporary shocks.
35
Horizon Countries
Yearly
Brazil, Guatemala (End of Year),
One-Two Years Canada (6-8 Quarters), Czech Republic (12-18 Months),
Ghana (18-24 Months),
Two Years
Chile (around two years), Israel (within two years),
Sweden (normally two years), Thailand (8 quarters)
Medium Term Armenia, Australia, Colombia, Hungary, Indonesia,
Mexico, New Zealand, Norway, Philippines (2012-2014),
Poland, Romania, Serbia, Iceland (on average), Peru (at
all times), UK (at all times), South Africa (on a
continuous basis).
Three Years
South Korea, Turkey (Multi year)
Bank of England Handbook
Q1-1983
Q4-1983
Q3-1984
Q2-1985
Q1-1986
Q4-1986
Q3-1987
Q2-1988
Q1-1989
Q4-1989
Q3-1990
Q2-1991
Q1-1992
Q4-1992
Q3-1993
Q2-1994
Q1-1995
Q4-1995
Q3-1996
Q2-1997
Q1-1998
Q4-1998
Q3-1999
Q2-2000
Q1-2001
Q4-2001
Q3-2002
Q2-2003
Q1-2004
Q4-2004
Q3-2005
Q2-2006
Q1-2007
Q4-2007
Q3-2008
Q2-2009
Q1-2010
Q4-2010
Q3-2011
Q2-2012
Q1-2013
Q4-2013
Korea Adopts Inflation Targeting in 1998
Korea: YoY CPI Inflation
12
10
8
6
4
2
0
IT Lite
• Some central banks will use inflation as a nominal anchor,
even announcing numerical goal for inflation without
adopting full-fledged inflation targeting (FFIT defining
targets, ranges, horizons, accountability mechanisms).
• Ex. U.S. Federal Reserve Monetary Policy Strategy The
Committee reaffirms its judgment that inflation at the rate
of 2 percent, as measured by the annual change in the
price index for personal consumption expenditures, is
most consistent over the longer run with the Federal
Reserve’s statutory mandate.
FOMC Monetary Policy Strategy & Longer Run Goals
• How much credibility will this build.
THE STRUCTURE OF CENTRAL
BANKS
Chapter 17
39
Principles of Monetary Policy Strategy Pt. II
Building Credibility
Monetary policy is subject to the timeinconsistency problem;
6. Central bank independence helps improve
the efficacy of monetary policy.
5.
Mishkin Monetary Policy Strategy: How Did We Get Here?
Expectations, Policy Credibility, and Transparency
39
40
5. Time Inconsistency
• Central banking goals benefit from anchoring
inflation expectations but if inflation expectations
become successfully anchored, a myopic
policymaker might take advantage to push up
output.
• Low inflation targets might not be time consistent.
• Since gov’t often has a short-term focus, it might be
difficult to build credibility for low inflation
expectations.
Expectations, Policy Credibility, and Transparency
40
Four Principles of Central Bank Design
• Society should design the state such that central bank is
•
•
•
•
able to resist the short-run imperatives of government but
still implement the goals of society
Independence
Decision Making by Committee
Accountability and Transparency
Policy Framework
Principles of Central Bank Design
1. Independence
• Strategies for Insulation
• Policy Independence: Central Bank sets day-to
day monetary policy free of direct government
control. Policy not reversible.
• Personal Independence: Long-terms of Office
for Central Bank Policymakers, difficult for
Central Bankers to be Fired.
• Revenue Independence: Central Bank has
independent sources of revenue.
Federal Reserve Structure
Board of Governors
Washington D.C.
(Direct Policy)
Regional Banks
(Monitor Regional Economy,
Local Interbank Payments)
New York Fed
(Implement
Monetary
Policy in
Financial
Markets,
Handle FX
Transactions)
Independence of US Federal Reserve
• Policy Independence: Monetary policy set by directors of
Federal Reserve of USA controlled & Regional Bank
• Personal Independence: Chairman of Fed serves across
Presidential terms. Presidents appointed by executive and
approved by legislature. Other policymakers serve terms of
either 5 or 14 years. They cannot be fired without votes of ⅔
of Congress.
• Revenue Independence: Fed earns profits through its
payment operations which constitute its budget.
Formation of a New Currency
• The countries of
Euroland needed to
replace national
central banks with a
single policy maker.
11 Countries adopt a single
currency in 1998, 18
countries by 2013.
Structure of the ECB
ECB Website
Independence of ECB
• Policy Independence: Monetary policy of ECB controlled by
Executive Council & National Bank Presidents. Decisions
cannot be reversed by national governments.
• Personal Independence: National Bank managers serve 5
year terms across Presidential terms. Board members serve 8
year terms.
• Revenue Independence: Budget provided by national central
banks which conduct most profitable operations
Independence of Bank of Japan
• Policy Independence: Monetary policy set by board.
• Personal Independence: Governor and Board members
have terms of five years, appointed by Cabinet approved
by Diet and House of Councillors.
• Budgetary Independence (?): Ministry of Finance must
approve budget.
Trend toward Independence
• 1998: Bank of Japan removed from direct control of Ministry
of Finance.
• 1998 Bank of England removed from direct control of the
Chancellor of the Exchequer.
• In 2003, Bank of Korea removed from direct control of
Ministry of Economy and Finance.
Monitoring the Monitors
• Reducing the impact of short-term political considerations
on decision making is important.
• But its also important in long-term to insure that central
bank serves goals of society and not own self interest.
Regulatory Capture
• Regulator of any industry may end up responding
to needs of industry rather than limiting them.
• Political influence or Hiring of Former Regulators.
• Buiter: Cognitive Regulatory Capture
• In USA, Regional Federal Reserves are governed
by local banks.
http://video.msn.com/video.aspx?mkt=enus&vid=f52ef280-e022-4fbd-a9a8-2cdcde182235
More Principles of Central Bank Design
How to monitor the central bank.
1. Decision Making by Committee
• Power should be diffuse within the central bank.
2. Accountability and Transparency
• Central Banks should make information about
their intentions and actions.
3. Policy Framework
• Banks should have a clear guideline for setting
their policy which meets the consensus of
society.
Decision Making by Committee
Interest Rate Setting
• Each of the Big 3 central banks sets a key interest rate by
committee. The decisions of these committees are closely
watched.
Bank
Committee
Rate
Fed
Federal Open Market
Committee
Governing Council
Fed Funds Rate
ECB
BoJ
Monetary Policy
Committee
Main Refinancing
Operation Rate
Uncollateralized
Overnight Call
Money Rates
Accountability and Transparency
• Publication of Policy Minutes
• Fed: Minutes
• ECB: Doesn’t Publish Critique
• BoJ Minutes
• Data, forecasts other research materials, presentations to
public and legislature.
• Federal Reserve must present report to Congress twice per year.
Hong Kong Monetary Authority
• HKMA formed in 1993 with merger of Exchange Fund and
Commissioner of Banking to perform role of the central
bank.
• Regulation of the Banking System
• Operation of the System of Payments
• Control of the Monetary Base
Prior to 1988, interbank settlement done on the books of HSBC
Independence of the HKMA?
• HKMA Policy Objectives
• “The HKMA is an integral part of the Hong Kong SAR Government.
The Chief Executive , appointed by the Financial Secretary,
remains a public officer….”
• “The Exchange Fund Advisory Committee …functions… as a
management board of the HKMA. The HKMA is accountable to the
public through the Financial Secretary.”
• Exchange Fund controlled by Financial Secretary.
• Decision to continue or abandon exchange rate peg lies
with Financial Secretary.
• Existence & Convertibility of HK dollar written into the
Basic Law.
• HKMA has control over its own budget.
OTHER GOALS
Business Cycle Stability
• Modern economies are beset by volatility in economic
output and employment.
• Does the pursuit of price stability come at the expense of
business cycle stability or are the two goals
complementary. Always?
1992 Q1
1992 Q3
1993 Q1
1993 Q3
1994 Q1
1994 Q3
1995 Q1
1995 Q3
1996 Q1
1996 Q3
1997 Q1
1997 Q3
1998 Q1
1998 Q3
1999 Q1
1999 Q3
2000 Q1
2000 Q3
2001 Q1
2001 Q3
2002 Q1
2002 Q3
2003 Q1
2003 Q3
2004 Q1
2004 Q3
2005 Q1
2005 Q3
2006 Q1
2006 Q3
2007 Q1
2007 Q3
2008 Q1
2008 Q3
2009 Q1
2009 Q3
2010 Q1
2010 Q3
2011 Q1
2011 Q3
2012 Q1
2012 Q3
2013 Q1
2013 Q3
2014 Q1
Unemployment Rate %
9.000
8.000
7.000
6.000
5.000
4.000
3.000
2.000
1.000
0.000
China, P.R.: Hong Kong
Korea, Republic of
Singapore
Exchange Rate Stability
• Hong Kong’s monetary policy emphasizes exchange rate
stability.
• Monetary Policy in Hong Kong
• Convertibility Undertaking: An undertaking by the Central bank to
convert domestic currency into foreign currency at a fixed
exchange rate.
• Linked Exchange Rate System: Since October 17, 1983,
Hong Kong has a convertibility undertaking with the US
dollar.
• Why?
Exchange Rate Stability
HK: Spot Exchange Rate: HKMA: HK$ to US Dollar
HKD to USD
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
Sep-1982
Sep-1985
Sep-1988
Sep-1991
Sep-1994
Sep-1997
Sep-2000
Sep-2003
65
Principles of Monetary Policy Strategy Pt. III.
Financial Stability?
Developments in the financial sector have a far
greater impact on economic activity than was
earlier realized.
8. The cost of cleaning up after a financial crisis is
very high.
9. Price and output stability do not insure financial
stability.
10. The zero lower bound on interest rates can be a
serious problem.
7.
Mishkin, Monetary Policy Strategy After the Crisis
Expectations, Policy Credibility, and Transparency
65
7. Increased Financialization in
Developed Countries
IMF World Economic Outlook 2008 Chapter 3
67
9. The cost of cleaning up after financial crises is very high.
Link
Challenges to Monetary Policy Effectiveness
9. Financial Instability
Economist Guide to Global Housing Markets
Financial Stability
• Financial Market Stability Financial markets and institutions
play an important role in moving funds from savers to
borrowers.
• Stock Market Stability
• Real Estate Market Stability
In recent years, bubbles and busts have beset markets.
• Interest Rate Stability: Businesses and consumers that rely on shortterm credit prefer a predictable exchange rate.
19900101
19901001
19910701
19920401
19930101
19931001
19940701
19950401
19960101
19961001
19970701
19980401
19990101
19991001
20000701
20010401
20020101
20021001
20030701
20040401
20050101
20051001
20060701
20070401
20080101
20081001
20090701
20100401
20110101
20111001
20120701
20130401
20140101
Zero Lower Bound
Zero Lower Bound
9
8
7
6
5
4
3
2
1
0
ECB Main Refinancing Rate
Japan Overnight Uncollateralized Call Money Rate
USA Federal Funds Rate
71
I. Two Views
Clean vs. Lean
•
•
Macroeconomic impact of recent financial
volatility has put renewed emphasis on the
role of monetary policy in ensuring
financial stability.
Two Views (Kohn, 2006)
A. Conventional View
B. Leaning against the Wind/Extra Action
71
Many Goals, Limited Powers
• Central banks are granted a small number of powers by
society and have a wide variety of aims.
• How do they use the powers they have to achieve all
goals.
• Important Question: Do they have enough tools at their
disposal to achieve all aims? What trade-offs do they face?
INTEREST RATES
REAL INTEREST RATES
Cecchetti, P. 80-84
Nominal and Real Interest Rates
• Nominal return represents how much money you will
receive after 1 year for giving up 1 dollar of money today
• Real return represents how many goods you can buy if
you give up the opportunity to buy 1 good today.
• Nominal interest rate is money interest rate. Real interest
rate is goods interest rate.
Interest on a Simple Loan
• Interest rates are always measured in
annual terms.
• Set T = # of years of a loan (may be
fraction)
A simple loan implies a loan of principal and
a single repayment which is the principal
plus interest.
Repaymentt+T  (1  it )t T  Principalt
• Imagine a 1 year loan [T =1]: The lender gives up
some goods to make a loan and will buy goods in the
future with the repayment.
Repaymentt+1
1  it 
Principalt
• If the price of goods at time t is Pt, the foregone current goods
are
Principalt
Pt
• The goods value of the future repayment is
Repaymentt+1
Pt+1
Real Interest Rate
• The real interest rate on the loan is defined as the future
goods received relative to current goods foregone
Repaymentt+1
1  rt 
Principalt
Pt+1
Repaymentt+1

Pt
1  it
1  rt 
 rt  it   t 1
1   t 1
Pt+1
Principalt
Pt
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be made before
future inflation is known so they must be made on the
basis of an ex ante (predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest rate is determined
by forces in the financial market. Money interest rate is
just the real ex ante rate plus the market’s consensus
forecast of inflation.
it  rt
EA

FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Ex Ante vs. Ex post
• We can also examine the ex post real return on a loan as
the money interest rate less the actual outcome for
inflation.
rt
ExP
 it  
ACTUAL
t 1
• The gap between actual and forecast inflation determines
the gap between the ex post (actual) and ex ante
(forecast) return.
ACTUAL
rt ExP  rt ExA   tFORECAST


1
t 1
Unexpected Inflation
Winners and Losers
• Higher than expected inflation means ex
post real rates are lower than ex ante.
Borrowers are winners/lenders are losers.
• Lower than expected inflation means ex
post real rates are higher than ex ante.
Lenders are losers/borrowers are winners.
The Inflation Tax
• Banknotes do not pay interest.
• The real interest rate on banknotes is
rt
CASH
  t 1
• If inflation is high, currency has sharply negative returns.
People will avoid holding money leading to society losing
the convenience of money transactions.
Identifying the Ex Ante Rate
• Calculating the ex post rate is straight-forward using
economic data.
• Calculating the ex ante rate is harder since markets
expected inflation is not directly observable.
• Option 1: Use survey data to elicit beliefs about inflation.
• Surveys of professional forecasters or perhaps consumers or
corporate executives (better for short-term).
• Option 2: Use yields on inflation protected securities.
• Many large countries treasuries issue bonds that guarantee a payoff in terms of purchasing power. The purchasing power yield that
the market is will to accept should be similar to real yield on other
assets (usually better for long-term).
Link
Importance of the Real Interest Rate
• Real interest rate is the intertemporal price of purchasing
power.
• If you buy 1 unit of purchasing power today, you give up 1+r units of
future purchasing power.
• It is the direct cost of credit for borrowers.
• An important determinant of the intertemporal allocation
Structure of Monetary Policy
Implementation
Tools
Direct powers of the
Central bank.
Operating
Instruments
Policy Feedback
Nominal
Anchor
Variable used to pin
down the value of
currency.
Policy/Operating Instruments
• “A variable that is very responsive to the central bank’s
tools and indicates the stance of monetary policy”
• Developed economies and emerging markets typically
choose between using a short-term interest rate or an
exchange rate as the instrument.
• Determines the implementation of monetary policy.