MGE 9.1

1

• Session 9 Stabilization policies (1) -
  Monetary Policy
• Goal How does central bank intervene? Why does
  it intervene?
• Monetary policy to stabilize economic
  fluctuations
• Tools of Monetary PolicyApplication Monetizing
  the Deficit
• Goals and Conflicts of Monetary Policy
• InflationApplications (1) The Yield Curve (2)
  The Japanese Deflation

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
Last time

• Unemployment
• Costs
• Lost production (big deal)
• Social costs (yep, thats a big deal)
• Distortionary costs (that too)
• Trade-off between unemployment and inflation
  (upcoming)
• Solutions
• Well see from your reports
• Flexibility
• but with mitigation of social costs
• and of fiscal costs
• This session Managing shocks -- monetary policy

3
Stabilization Fiscal and/or Monetary Policy to
smooth fluctuations

• Why?
• Unemployment in recessions
• Inflation when overheating
• Stabilization policy, but
• Overstimulation means
• Understimulation leads to

inflation
unemployment
4
Monetary Policy to move out of recession




LM1



r

r






r

1

L
(
Y
)


IS1
M
/P

1
Output

Real money
Y

recession
balances

5
Monetary Policy to move out of recession



1. An increase in M


LM1



r

r






r

1

L
(
Y
)


IS1
M
/P

M
/P

1
2
Output

Real money
Y

recession
balances

6
Monetary Policy to move out of recession



1. An in
crease in M


LM1



r

r






r

1

L
(
Y
)


IS1
M
/P

M
/P

1
2
Output

Real money
Y

recession
balances

2. leads to a decrease in r

7
Monetary Policy to move out of recession



1. An in
crease in M


LM1

LM2


r

r






r

1

L
(
Y
)


IS1
M
/P

M
/P

1
Output

2
Real money
Y

recession
balances

3. which shifts the LM curve
downwards

2. leads to a decrease in r

8
Monetary Policy to move out of recession



1. An increase in M


4.lower r leads to higher I, leads to higher Y


LM2


r

r






r

1

r

2
L
(
Y
)


IS1
M
/P

M
/P

1
Output

2
Real money
Y

Y

recession
FE
balances

3. which shifts the LM curve
downwards

2. leads to a decrease in r

9
Monetary Policy to move out of recession



1. An increase in M


4.lower r leads to higher I, leads to higher Y


LM2


r

r

5. Higher returns on stock market higher Y
leads to higher money demand






r

1

r

2
L
(
Y
)


IS1
M
/P

M
/P

1
Output

2
Real money
Y

Y

recession
FE
balances

3. which shifts the LM curve
downward
s

2. leads to a decrease in r

10
Adjustment to Negative AD Shock Automatic



Price level

Negative AD shock

(Inflation)






SRAS

P
o

P
SR

ADCIGNX
AD
CIGNX

2
Output/income

Y
Y
SR

FE

(Growth)

Short-run reaction
11
Adjustment to Negative AD Shock Automatic


Unemployment gt real wages fall

Price level


(Inflation)






SRAS

P
o

P
SR

P
LR

AD
CIGNX

2
Output/income

Y
Y
SR

FE

(Growth)
Long-run reaction

12
Adjustment to Negative AD Shock Monetary Policy

Mon. policy boots aggregate demand (Investment
multiplier effect)


Price level


(Inflation)






SRAS

P
P
LR

o

P
SR

AD

3
AD
CIGNX

2
Output/income

Y
Y
SR

FE

(Growth)

13
Adjustment to Negative Aggregate Demand Shock



Monetary Policy

Automatic Adjustment




Price level

Price level


(Inflation)
(Inflation)





SRAS

SRAS
P
P
o

o

P
P
SR

SR

P
LR

AD

AD

Y
Y
Y
SR

FE

Y
SR

FE

Output/income

Output/income

(Growth)
(Growth)


UE gt real wages fall
MP to boost AD
14
Adjustment to Positive Aggregate Demand Shock



Monetary Policy

Automatic Adjustment




Price level

Price level


(Inflation)
(Inflation)




P
LR


SRAS

SRAS
P
P
SR

SR

P
P
o

o

AD

AD

Y
Y
Y
SR

FE

Y
SR

FE

Output/income

Output/income

(Growth)
(Growth)


Tight labor gt real wages rise
MP to cool AD
15
Adjustment to Aggregate Supply ShockAutomatic
adjustment


Price level


(Inflation)





P

SR

SRAS


P
o

ADCIGNX

Output/income

Y
Y
SR

FE

(Growth)

16
Adjustment to Aggregate Supply ShockMonetary
Policy


Price level



(Inflation)
SRAS




P

LR

P

SR

SRAS


P
o

AD

ADCIGNX

Output/income

Y
Y
SR

FE

(Growth)

17
Adjustment to Aggregate Supply shock



Monetary Policy

Automatic Adjustment




Price level

Price level


(Inflation)
(Inflation)





SRAS

SRAS
P
LR

P
P
SR

SR

P
o

P
P
o

LR

AD


AD
Y
Y
Y
SR

FE

Y
SR

FE

Output/income

Output/income

(Growth)
(Growth)


UE gt real wages fall
MP to boost AD
18
How fast does Adjustment happen?

• Start off from full employment
• Tighten monetary policy (why?)

0.8
0.6
Percentage change in levels from time 0
0.4
Interest rate
0.2
GDP deflator
Real GDP
0
- 0.2
0
4
8
12
16
20
24
28
32
36
40
44
48
months
Smoothed results from Bernanke and Gertler (1995)
19
Typical results
Source Giannone and Reichlin (2003)
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Instruments of Monetary Policy

• Central banks affect money supply through four
  different channels
• Open market operations buy and selling
  government securities
• Required reserve ratios restrictions on how
  much of the deposits banks can lend out (almost
  never used)
• Reserve lending policy setting discount and
  Lombard rates, which affect the prices of
  inter-bank (overnight) loans
• Direct credit to government seigniorage
  (printing money)

21
A Typical Bank Balance Sheet
22
Tools (1) Open market operations

• Open market purchase increase money supply
• Open market sale reduce money supply
• NOTE Central Bank does not control interest
  rates directly! It decides on a target for
  interest rates and then buys or sells bonds to
  achieve target.
•  
• To lower interest rates, do bond prices have to
  go up or down?

23
Tools (2) Reserve Requirements (1995)
24
Tools (3) Reserve Lending

• Banks borrower from each other to satisfy reserve
  needs or, as a last case resort, they can borrow
  from Central Bank.
• The discount rate (or refinancing rates)
• Typically the lowest rate at which banks can
  borrow reserves (from the Central Bank)
• Amounts are limited by quota
• Lombard rate
• Highest rates charged by the Central Bank for
  emergency loans

25
(No Transcript)
26
One interest rate?
Source http//www.federalreserve.gov/releases/h15
/data.htm
27
Why do discount/Lombard rates affectMoney Supply?

• Reflect the prices of reserves, and thus the
  price that banks charge each other for loans
• The higher the rates, the more excess reserves
  banks keep (to lend, or such as not to borrow)

28
Tools (4) Direct credit to government

• Instead of buying government bonds from the open
  market, the central bank can create money supply
  by buying them directly from government.
• Seigniorage difference between face value of
  note and cost of printing it
• Monetizing the deficit
• Seigniorage revenues
• Problem inflation tax

29
Application Inflation Tax
Lend 100 at 10 real return

• No inflation case
• 10 predictable inflation case (no uncertainty)

30
Application Inflation Tax
Lend 100 at 10 real return

• No inflation case

31
Application Inflation Tax
Lend 100 at 10 real return

• 10 completely predictable inflation case

Discourages lending!
(and thus investment!)
32
III. Goals and Conflicts of Monetary Policy

• Goal for most Central Banks price stability
  (low inflation)
• Problem might be in conflict with the political
  goals of the government (reduce unemployment,
  increase output, lower interest rates)
• Particular problem in election years
• Short-run benefits met by inflation in long run
• Changes in inflationary expectations

33
Central Bank Independence
34
Costs of inflation

• Expected inflation
• Shoe-leather costs (more trips to the bank to
  avoid inflation)
• Menu costs (adjustment of prices)
• Variability in relative prices (inflation does
  not hit all prices the same)
• Inflation tax (discouraging lending)
• Failure of households to properly account for
  inflation

35
Costs of inflation

• Unexpected inflation
• Redistribution of wealth (contracts set in
  nominal terms)
• Increase variability hurts business decision
  making
• Variability (and uncertainty) in relative prices
• Increase cost of credit (risk premium)

36
Inflation Grease or Sand

• Money illusion (grease)
• Workers like nominal wage increases even if no
  change in real wage
• Good for the economy
• More uncertainty (sand)
• Firms likely to misjudge overall rise in nominal
  wages
• More conflicts with relative wages (10
  difference becomes larger)

37
Monetary policy and Nominal interest rates

• To reduce inflation, reduce money supply ?
  nominal interest rates go up.
• However, lower future inflation should cause a
  fall in nominal interest rates since
• Which way will they go?

38
The Yield Curve

• Can infer market expectations about future
  short-term rates by looking at difference between
  current short-term rates and long-term rates
• ex
• investing in a two-year bond (annual yield y2)
• has to give same expected value than
• investing in a one-year bond twice in a row
  (annual yield i1 and i2)
• (1y2)2 (1i1) (1Ei2)

39
The Yield Curve

• (1y2)2 (1i1) (1Ei2)

0.25
0.14
0.03
40
Current Yield Curves
41
Application The Japanese Deflation
42
Application The Japanese Deflation

• Slump began with stockmarket crash in 1989
• Why is deflation an important problem?
• Corporate profits are falling falling prices
  sticky (high) wages
• Non-performing loans on the rise (also culture of
  unacceptable bankruptcy)
• The Bank of Japans problem (BoJ)
• Very low nominal interest rates (overnight call
  0 Libor 0.05)
• But deflation, so real rates are positive
• No margin for maneuver

43
Application The Japanese Deflation

• What could Japan do?
• Print money
• Create inflation to lower real interest rates
• Would lead to a devaluation of the Yen exports
  more competitive
• Limit government spending (net debt 72 of GDP
  at end of 2002)
• Effect on real interest rates
• What is Japan doing?
• Letting the Yen depreciate (and even intervening
  to keep it low)
• Why?
• Political pressure to intervene, but BoJ does not
  want to be seen as compromising its independence

44
Application The Japanese Deflation

• Further measures Boost confidence in banking
  sector
• Better accounting systems (identify
  non-performing loans)
• Auction off NPLs
• Liquidation of overvalued assets real estate,
  productive assets, and the failing companies that
  hold them
• No one is going to be willing to invest in new
  assets if the possibility exists that existing
  assets will be dumped on the market
• Recapitalization of the banks
• Discount sales of assets will make Japanese banks
  insolvent
• Solution Government buys shares, and sells them
  back once banks have returned to profitability

45
Summary of session 9

• Monetary policy affect interest rates to affect
  economic activity
• Problem with any aggregate demand policy
  inflation
• Independent monetary authority to avoid
  temptation of short-run stimulation of the
  economy for political reasons (at the cost of
  long-run inflation)
• Costs of inflation shoe-leather costs
  increased uncertainty
• Yield curves depict expectations about future
  inflation