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Unformatted text preview: What Should Central Banks Do? Monetary Policy Goals Strategy and Tactics Mishkin (8th Ed.) Chapter 16
ECON 311 Elif Akbostanci
1 Price Stability is perceived as low and stable inflation and viewed as the most important goal of monetary policy in the recent years. Down sides of inflation: Inflation leads to uncertainty uncertainty hampers growth. Due to uncertainty it is harder to interpret the message conveyed by the prices. It complicates decision making for The Price Stability Goal and Inflation consumers businesses government
2 It will lead to a less efficient financial system. It will make it difficult to plan for the future. Nominal Anchor is a nominal variable such as the inflation rate, money supply or any monetary aggregate, or the exchange rate that monetary policymakers use to tie down the price level. Use of nominal anchor means that the nominal variable that is chosen as the anchor is kept in a narrow range, which in turn will help achieving price stability goal by promoting low and stable inflation expectations. So in effect nominal anchor means that the monetary authority targets the selected anchor by keeping it at a predetermined level or range. A major advantage of the nominal anchor is that it can reduce the time inconsistency problem.
3 Nominal Anchor It is a situation where decision makers' preferences change through time. So lets say that the decision maker makes a commitment today at time t, but after time passes, at time t+n, she might decide to not to commit to that decision and act differently. Some examples of time inconsistency: Smokers' long term health requires them to quit smoking. A smoker might decide to quit smoking tomorrow. But when tomorrow comes she might change her mind and decide to smoke one more to enjoy the pleasures of smoking in the shortrun! To encourage research, the government announces that it will give a temporary monopoly to companies that discover new drugs. But after a drug has been discovered, the government is tempted to revoke the patent or to regulate the price to make the drug more affordable. (Mankiw)
4 Time Inconsistency Problem To encourage good behavior, a parent announces that he or she will punish a child whenever the child breaks a rule. But after the child has misbehaved, the parent is tempted to forgive the transgression, because punishment is unpleasant for the parent as well as for the child. (Mankiw) The announced policy of many nations is that they will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping hostages, rational terrorists won't kidnap any. In other words, the purpose of the announcement is to influence the expectations of terrorists and thereby their behavior. But, in fact, unless the policymakers are credibly committed to the policy, the announcement has little effect. Terrorists know that once hostages are taken, policymakers face an overwhelming temptation to make some concession to obtain the hostages' release. The only way to deter rational terrorists is to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take 5 hostages would be largely eliminated. (Mankiw) Rules vs. Discretion Time inconsistency Problem in Monetary Policy
Discretion: takdir yetkisi From an economic perspective, the issue of time inconsistency emphasizes the problem of unpredictably changing incentives over time. In terms of monetary policy discretion at first glance is superior to a fixed policy rule. As long as you can trust your policy makers and presume that they are intelligent and benevolent there might not be an apparent reason to deny them the flexibility in responding to changing conditions.
6 A central bank will have better inflation performance in the longrun if it does not surprise people with unexpected expansionary policy. However when monetary policy is at the discretion of policy makers there is always the possibility that in the short run they might use expansionary policy. One approach to achieving time consistency in monetary policy is to limit policy to rules that the monetary authority will have an incentive to pursue in all normal future circumstances. This way monetary policy will become time consistent. Having a nominal anchor is one way of committing to a rule, which will eliminate or at least reduce the time inconsistency problem.
7 Other Goals of Monetary Policy High employment: Unemployment causes human misery. It means idle resources i.e. inefficient allocation of resources. Natural rate of unemployment (NAIRU): the level of unemployment consistent with full employment. (UE0) (Frictional +structural unemployment) High economic growth Interest rate stability Stability of financial markets Stability of foreign exchange markets
8 Should Price Stability be Primary Goal of Monetary Policy?
Mandate: manda, emir, buyruk Hierarchical mandates: Mandates that put price stability goal first, and as long as it is achieved other goals can be pursued. Examples: CBRT, European Central Bank, Bank of Canada, Reserve bank of New Zealand, Bank of England. Dual mandates: Mandates that promote two coequal objectives: price stability and maximum employment. Ex. Federal Reserve Bank of US.
9 In theory these two mandates might imply the same thing as in the longrun there is no inconsistency between achieving price stability and the natural rate of unemployment. In the hierarchical mandate attempts to keep inflation at the same level no matter what, would likely to lead excessive output fluctuations. The goal of price stability should be only a long run goal and reducing output fluctuations should be also a concern of monetary policy. Dual mandates on the other hand could create time inconsistency problem. A dual mandate might lead the CB to pursue shortrun expansionary policies that increase output and employment without worrying about the long run consequences for inflation. Conclusion: Both mandates could work as long as they put the price stability as the longrun goal, not the shortrun goal. 10 Monetary Policy Strategies to Achieve Price Stability Monetary Targeting Inflation Targeting Implicit Nominal Anchor 11 Monetary Targeting In this strategy the Central Bank (CB) announces that it will achieve a certain value (target) of the annual growth rate of a monetary aggregate such as 4% growth rate of M1 or 6% growth rate of M3 etc. The CB is accountable for hitting the target. This was initially suggested by Milton Friedman that the monetary aggregate should grow at a constant rate. In the 1970's monetary targeting was adopted by Germany, Switzerland, Canada, the UK, Japan and the US. But it was not pursued very seriously in some of these countries. In the 1980's it was found that monetary aggregates were not a reliable guide to monetary policy and monetary targeting is abandoned by many of these countries.
12 Advantages of Monetary Targeting: Disadvantages of Monetary Targeting: Immediate knowledge about the achievement of the target. Monetary aggregate figures are reported within weeks. Immediate signaling regarding the stance of monetary policy to the economic agents. (stance: duru, durum) Immediate accountability for monetary policy. Thus monetary policy maker is constrained from falling into time inconsistency trap. The relationship between the goal variable (inflation or nominal income) and the target variable (monetary aggregate) is weak. Therefore hitting the target will not guarantee that you will reach your goal. Thus monetary aggregate will no longer provide an adequate signal about the stance of monetary policy. In this case MT will not fix inflationary expectations and will not be a good guide in assessing CB accountability. 13 Inflation targeting (IT) involves several elements: 1. Public announcement of mediumterm numerical targets for inflation. 2. An institutional commitment to price stability as the primary longrun goal, and a commitment to the inflation target. 3. An informationinclusive approach in which many variables besides the monetary aggregates are used in decision making. 4. Increased transparency of monetary policy strategy; communication with the public about the plans and objectives of monetary policy makers. 5. Increased accountability of the CB for attaining its inflation objectives.
14 Inflation Targeting Given the breakdown of the relationship between monetary aggregate and inflation many countries have recently adopted inflation targeting as their monetary policy strategy in achieving price stability. New Zealand was the first country to adopt IT in 1990 Canada 1991 UK 1992 Sweden and Finland 1993 Austria and Spain in 1994 Israel, Chile, Brazil are others to adopt IT Turkey's IT experience is coming up!
15 Advantages of Inflation Targeting: A stable moneyinflation relationship is not necessary for its success. CB uses all the relevant information to determine the monetary policy. Simplicity and clarity of the target. Inflation target is easily understood by the public and highly transparent. An explicit numerical target increases the accountability of the CB. Time inconsistency problem is less likely. Increased stress on making policy transparent and on regular communication with public improved private sector planning by reducing uncertainty. 16 Disadvantages of Inflation Targeting: Delayed signaling: Inflation is not easy to control and outcomes are revealed only after a substantial lag. Therefore IT is not able to send immediate signals to the public about the stance of the policy. Too much rigidity: Since it imposes a rigid rule it may restrict policymakers' ability to respond to unforeseen circumstances. However in practice it is far from rigid, it never requires the CB to focus on a key variable. CB utilizes all the available information. Also inflation targets have been modified depending on economic circumstances. Potential for increased output fluctuations: Sole focus on inflation may lead to too tight monetary policy, and may cause increased output fluctuations. However inflation targeters usually set target rates above zero and display concern about output fluctuations as well. Low economic growth: Disinflation usually associated with low growth, however once low inflation levels are achieved output and employment is expected to 17 recover. Once low inflation is achieved IT is not harmful to the real economy. Implicit Nominal Anchor FED's Policy
M. Friedman stated that monetary policy effects have long lags. In industrialized countries inflation process have a large inertia. For example for the US economy monetary policy takes over a year to affect the output and over two years to affect inflation. However countries that experienced high and variable inflation will have more flexible prices and shorter lags. The presence of long lags means that monetary policy can not wait until inflation has begun to respond. To prevent inflation therefore monetary policy needs to be forward looking and preemptive. (preemptive: nleyici) FED under Alan Greenspan used the implicit nominal anchor policy which differs from IT in that it does not officially (explicitly) have a nominal anchor and is much less transparent in its monetary policy strategy.
18 Advantages of Implicit Nominal Anchor: Disadvantages of Implicit Nominal Anchor: Does not rely on stable moneyinflation relationship. CB uses all the available information to determine the best settings for the monetary policy. Demonstrated success in US. Lack of transparency: It creates uncertainty and unnecessary volatility in the financial markets. Lack of accountability: No predetermined criteria for judging the success of the FED. Success of the policy is highly dependent on the preferences, skills and trustworthiness of individuals in charge of the central bank.
19 Policy Instrument (Operating Instrument): is a Choosing the Policy Instrument variable that respond to CB's tool and indicates the stance of the monetary policy (easytight). Reserve aggregates: total reserves, nonborrowed reserves, monetary base etc. Interest rates: short term interest rates. Intermediate Target: these stand in between the policy instrument and the monetary policy goals and are not directly affected by the tools of monetary policy but more closely linked with the goals. M2, M3 Longterm interest rates 20 Policy Instrument Intermediate Target Monetary Policy Goals For Example: Long term interest rate Price Stability O/N Rate 21 Targeting Non Borrowed Reserves 22 Targeting Interbank Rate 23 Criteria For Choosing Policy Instrument
Observability and measurability Interest rates are more observable and easily measurable than monetary aggregates. However; it is the nominal interest rates that we observe and it is a poor measure of the actual cost of borrowing i.e. the real interest rate. The real interest rate is not observable. (ir = i e) Controllability: CB must be able to exercise effective control over the variable. Monetary aggregates are harder to control due to shifts in and out of currency. It is easier to control the short term interest rate (nominal). However the CB can not set the real interest rate. Predictable Effect on Goals: In recent years it is believed that the link between interest rates and inflation is tighter than monetary aggregates and inflation. Conclusion: CB's throughout the world use shortterm interest 24 rates as their policy instrument. Taylor Rule
How should the target of shortterm interest rates be chosen? A suggestion is made by John Taylor, called the Taylor rule stated as follows: interest rate target= inflation rate + equilibrium interest rate+ 0.5 (inflation gap)+0.5 (output gap) Where; Inflation gap = Current inflationtarget rate Output gap= % deviation of real GDP from full employment level (potential GDP)
25 Inflation Targeting in Turkey 26 Implicit Inflation Targeting: 20022005 Fully fledged IT: 2006 onwards Turkish Experience In the aftermath of the 2001 crisis before the implicit IT has started Floating exchange rate regime was introduced CB law was amended to increase the CB's independence Primary goal of CB is defined as price stability Credit to public sector is eliminated "Strengthening the Turkish EconomyTurkey's Transition Program" was launched which addressed two main issues: Chronic inflation and high public debt.
27 The policy between 20022005 is defined as inflation targeting because: Price stability as primary objective A unique numeric target for annual inflation Shortterm interest rate as policy instrument It was also "implicit" because: Preconditions were not yet fulfilled Base money used as temporary anchor
28 Inflation Targeting Practice Point Target: Endyear CPI Uncertainty Bands: +/2 percentage points Target Horizon: 3year horizon Forecast Horizon: 6 quarters Policy Instrument: O/N rate (%5 for 2006, %4 for 2007 and 2008) Decision Making Body: MPC Main Communication Tool: Inflation Report
29 (Preannounced monthly meetings) Source: Kara & Orak, 2008 30 Inflation Target and Realizations
Inflation* Target Actual Difference 2002 35 29.7 5.3 2003 20 18.4 1.6 2004 12 9.3 2.7 2005 8 7.7 0.3 2006 2007 5 9.7 4.7 4 8.4 2008 2009 4 9.3 4 4.4 *CPI, year to year percentage change CB's estimation Source: CBRT 31 Due to developments in 2008 (global financial turmoil and crisis) CB have revised up the end2008 inflation forecast to % 11.1. Accordingly CB adjusted the inflation target rates of %4 from 20092011 to the following rates: 2009 % 7.5 2010 % 6.5 2011 % 5.5 CPI inflation rates: 2008 %10.06 2009 %5.27 (3 quarters)
32 33 Performance in 2009 34 Performance in 2008 Source: CBRT Inflation Report IV, 2008 35 36 Growth Performance GDP in 1987 prices
8.0 6.0 3.1 2.1 2.0 0.3 0.0 % 0.9 7.2 7.0 7.5 7.4 12.0 10.0 8.0 6.0 4.0 9.3 7.9 5.8 8.9 7.4 6.1 4.2 1989 1990 1992 1993 1995 1997 1998 2003 2004 2006 -2.0 -4.0 -6.0 -8.0 -10.0 -5.5 -4.7 -7.5
37 Source: TURKSTAT 2007 1988 1991 1994 1996 1999 2000 2001 2002 2005 Source: CBRT Inflation Report IV, 2009 38 Source: CBRT Inflation Report IV, 2009 39 Source: CBRT Inflation Report IV, 2009 40 Inflation Subcomponents Source: CBRT Inflation Report IV, 2008 41 Source: CBRT Inflation Report IV, 2008 42 Source: CBRT Inflation Report IV, 2009 43 Inflationary Expectations Source: CBRT Inflation Report IV, 2008 44 Source: CBRT Inflation Report IV, 2009 45 Inflation Around the World 46 Source: CBRT Inflation Report IV, 2009 47 Reasons for Poor Performance Supply side shocks Stickiness in service sector prices (2006) Increase in oil and gold prices in international markets Increase in prices of tobacco and unprocessed food Financial market turbulence in 2006 MayJune Financial market turbulance in 2008 Worsening inflationary expectations Capital outflows originated from the deterioration of global liquidity conditions and depreciation of YTL 48 CB Monetary Policy H index: CPI excluding unprocessed food, energy, tobacco and alcoholic beverages and gold prices. 49 CB's Response 50 Monetary Policy Decisions During Inflation Targeting Period in Turkey Source: CBRT Inflation Report II, 2009 51 Source: CBRT Inflation Report II, 2009 52 53 Challenges Ahead Abandoning fiscal discipline Staggering structural reforms External shocks Oil prices primary surplus target for 2008 is reduced to 3.5% from 4.2%. Primary surplus targets for 2009, 2010 and 2011 are set to 3%, 2.7% and 2.5% respectively. Food prices, commodities prices Change in global risk perception Interruption of accession and convergence process to the EU 54 Is the Upcoming Recession a Chance for Inflation? Source: CBRT Inflation Report IV, 2008 55 Source: CBRT Inflation Report II, 2009 56 ...
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