Political Economy of Monetary Policy

1
Political Economyof Monetary Policy
November 2003
2
Presentation Index

• Introduction.
• Areas of Interest.
• Endogenous Monetary Policy Formulation
• Fiscal and Monetary Policy
• Foreign Exchange Arrangement and Monetary Policy
• Unemployment, Inflation and Monetary Policy.
• QA

3
Introduction

• The objective of monetary policy is to influence
  the performance of the economy as reflected in
  such factors as inflation, economic output and
  employment. It works by affecting aggregate
  demand across the economy, specifically peoples
  and firms willingness to spend money on goods
  and services.
• Monetary policy is conducted by a nations
  central bank and influences demand by targeting
  (raising or lowering) short term interest rates
  or controlling the money supply.
• Monetary policy has two basic goals to promote
  maximum output and employment, and to promote
  stable prices.

4
The presentation will be based on certain aspect
of political Economy and monetary policy

• Kliponen
• Parkin

• Edwards
• Frieden
• Leblang

• Havrilesky

• Bach
• Kaley et al
• Persson et al

5
The Political Economy of Monetary Policy
(Havrilesky, 1994)
Objective
Public Choice Model
Previous Theories
6
Optimal Fiscal and Monetary Policy and Economic
Growth Foley et al (Journal of Political
Economy)

• Government goals
• Maximization of utility of per capita consumption
  (social welfare)
• Management of aggregate demand to achieve stable
  consumer price level (maintenance of
• price stability)
• Government tools
• Its deficit appears as transfer income and
  influences the demand for consumption goods.
• It intervenes at the asset market by open market
  policy it affects price of capital and
  therefore
• economys growth path.
• (Therefore, it manipulates deficit and OMP to
  induce the private sector to produce investment
  goods
• at the optimal rate at each instant).
• Optimal per capita deficit is an increasing
  function of the capital labor ratio.
• Initial debt has no influence on economys growth
  path Economys growth possibilities are only
• constrained by its technology and its
  initial endowments of capital and labor.
• The economy seeking the higher long-run per
  capita consumption (less impatient government)
• may follow a fiscal and monetary policy leading
  to a higher long-run per capita debt.
• The higher the communitys propensity to save,
  the higher is the long run debt (taking the

7
Monetary-Fiscal Policy Reconsidered - G.I. Bach
(Journal of Political Economy)

• Instead of guaranteeing full employment
  without inflation, in a free society
  monetary-fiscal policy may well guarantee
  inflation without full employment because of the
  upward income pressures of monopolies and
  organized political power groups.
• Government has two goals price stability
  and full employment
• Author proposes 6 assumptions for the
  workable monetary-fiscal policy One of them is
  For effective policy monetary-fiscal authority
  must operate without irresistible pressures from
  special interest groups (business, labor and
  agriculture) seeking to place their welfare above
  that of the general public.
• While interest groups are exerting
  expansionary pressures on government, Government
  is acting as a protector of the income of a
  particular social group the unorganized
  fixed-income receivers.
• Upward income and price pressure cannot be
  effectively resisted by a government whose
  monetary-fiscal guide is full employment.
• Necessary condition for successful
  monetary-fiscal policy is voluntary consensus
  among interest groups (public support).

8
Time Consistency of Fiscal and Monetary Policy
Persson et al (Econometrica)

• The problem of time inconsistency arises from
• Incentive for each government to engage in an
  initial unanticipated inflation
• Incentive for each government to deviate from the
  path of taxes announced by the preceding
  government
• Government under discretion has an incentive to
  deviate from previously announced policy.
• Suggestions 1) Fixed rules commitment policy
• 2) Reputation issue
  (allows discretion policy)
• 3) Carefully
  managed structure of debt each new government
  had to honor the previous government debt (allows
  discretionary policy)
• 1 - Each government should leave to its successor
  net nominal claims on the private sector equal to
  the money stock
• 2 - Government has to engage in partial
  commitment just to honor previous national
  debt. New government inherits the right maturity
  structure of its nominal and indexed debt, which
  enables it to conduct optimal policy without time
  inconsistency.

9
Exchange Rate and the Political Economy of
Macroeconomic Discipline (Edwards, 1996)
Research Objective
Results
Sign on Coefficient
Political Instability
Bilateral exchange-rate changes
Variation of real export
Methodology
Degree of Openness
Domestic Liquiditys Growth Rate
Inflation History
International Reserves
Real GDP growth
Per Capita GDP
10
Exchange Rate and the Political Economy of
Macroeconomic Discipline (Edwards, 1996)
Details -
Results
Coefficient
Description
Sign
Transfer of Power (break in the partys control
of executive power). Politically unstable
Countries will have a LP of adopting a fixed peg
exchange rate system.
Political Instability
TP
Coefficient of real bilateral FOREX changes.
Countries with a greater bilateral exchange-rate
fluctuations will LP adopt a fix peg
Bilateral exchange rate changes
EXVAR
Coefficient of real export growth (1970-80).
Countries with a greater increase in export
growth will LP adopt a fix peg
Variation of real export
CVEX
TRADE/GDP ratio. The probability of choosing a
pegged exchange rate declines with higher levels
of openness
Degree of Openness
VAR-OPEN
Five year moving average. The probability of
choosing a pegged exchange rate declines with
higher rates of dom liquidity increase
Domestic Liquiditys Growth Rate
CREGRO
historical, log inflation rate for 1970-80. The
probability of choosing a pegged exchange rate
declines with higher levels of ?
Inflation History
LOGINF
one-year lagged ratio of inter reserves to
high-powered money. More reserves, less likely
to abandoning the peg.
International Reserves
RESMONEY
Average REAL growth rate . Proxy for tie hands.
Countries with historically low growth rate will
be more tempted to overinflate and hence prefer a
more rigid regime
Real GDP growth
GROWTH
log of GDP per capita measured in 1989 dollars.
More advanced countries will have a tendency to
select more flexible exchange rate systems
Per Capita GDP
PCGDP
11
The Political Economy of Currency Pegs (Frieden,
2003) The Political Economy of Exchange Rate
Policy (Leblang, 2003)
Research Objective (Frieden)
Research Objective (Leblang)
Methodology
Methodology
Findings
Findings
12
The Political Economy of Monetary Policy and Wage
Bargaining (Kilponen, 2000)

• When wage setters commit to an inflation
  targeting régime, inflation can reach the target
  level, but there may be a substantial loss in
  output. The loss in output is related by the
  desire of the central bank to accommodate related
  labor market distortions.
• When labor markets are sufficiently
  decentralized, regardless of the weight the
  government attaches to output stabilization, the
  government would prefer explicit inflation
  targeting over discretion even if the wage
  setters had a possibility to precommit.
  Additionally, under discretion, the whole society
  would be better off, especially unions.
• When the wage setters responded to the policy
  rule of the government, it was found that the
  governments policy was not time inconsistent in
  the usual sense of creating inflationary bias,
  because the government would find it optimal to
  reduce inflation.

13
Unemployment and Inflation (Parkin, 1998)

• Optimally, monetary policy should set a short
  term interest rate and a contingency rule to
  target zero inflation, and to smooth out
  fluctuations in unemployment.
• The general view is that the natural unemployment
  rate fluctuates and the trade-off between the
  change in inflation and unemployment is
  influenced by many factors rates of entry and
  exit into job market, unemployment compensation
  arrangements.
• The trade off between the change of unemployment
  and inflation is of limited policy relevance.
• Dynamic General Equilibrium (DGE) Model-shows the
  design and conduct of monetary policy would make
  predictions about the influence of monetary
  actions on unemployment and inflation.
• Combines production technology, job matching
  technology, shopping-time technology, and price
  setting technology into one model.
• Shocks to this model would show how other sectors
  would recover when one sector is hampered.