Economic Policy in the European Union Prof' Edwin G' Dolan University of Economics, Prague, 2006

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Economic Policy in the European Union Prof.
Edwin G. DolanUniversity of Economics, Prague,
2006
Lecture 10In Search of Monetary Stability
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Money as the Economys Nominal Anchor

• Money is the economys nominal anchor
• Equation of exchange
• MV PQ
• Where
• M the money stock
• V velocity
• P the price level
• Q real output (real GDP)

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Qui custodiet ipsos custodes?

• Central bankers have often been a source of
  instability
• Hyperinflation resulting from monetization of
  budget deficits
• Deflation resulting from inadequate market
  flexibility
• Procyclical policy resulting from
  time-inconsistency
• Is there some way to do better?
• A closer look at the sources of monetary
  instability
• How well could central bankers stabilize the
  economy if they tried?
• Is money too important to be left to central
  bankers?

Central bankers are the guardians of monetary
stabilitybut who will guard the guardians?
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• Part 1
• Lags and Forecasting Errors

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Stabilization in a world without lags (1)

• Suppose there were no delay between use of
  instruments and changes in target variables
• To maintain price stability and natural level of
  unemployment it would only be necessary to
  control growth of aggregate demand

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Stabilization in a world without lags

• Position of AD curve depends on control of
  nominal GDP
• Equation of exchange MVPQ
• M money multiplier X monetary base (B)
• Money multiplier (1CUR)/(RESCUR)
• By substitution,
  ((1CUR)/(RESCUR))BV PQ
• Without lags, any change in the money multiplier
  or velocity could immediately be offset by a
  change in the monetary base

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Important lags in monetary policy

• Inside lags
• Delay between the time a problem occurs and the
  time we learn about it
• Delay between the time we learn about a problem
  and the time we take action

• Outside lag
• Delay between the time we use a policy instrument
  and the time of a change in chosen intermediate
  targets

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Inside lags

• Lags in data collection
• Daily
• interest rates
• exchange rates
• monetary aggregates
• Monthly
• inflation
• unemployment
• Quarterly (subject to revision)
• GDP
• Balance of payments
• Because of noise, multiple observations are
  needed to spot a trend, increasing lags

• Other inside lags
• In US, Federal open market committee meets 8
  times a year
• Need of central bank staff to prepare technical
  reports for top decision makers
• Need of central bank to consult other agencies

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Lags in US GDP Data

• Data on US National Income and Product Accounts
  (NIPA) are released quarterly in three revisions
• Advance (one month after end of quarter)
• Preliminary (two months after end of quarter)
• Final (three months after end of quarter)
• Final estimate subject to revision up to
  several years later
• For GDP growth, standard deviation of adjustment
  from preliminary to final is .4 percentage points
• Example If advance estimate of Q4 2005 GDP
  growth is 3.5, 95 confidence interval is about
  2.7-4.3

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Example GDP Growth in 2001 recession

• Last US recession was
• Jan-Nov 2001
• As of mid-recession (May 2001), GDP growth data
  showed slowdown but no indication that recession
  had started
• Notice large amount of noise in both 2001 and
  2006 vintage data

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Outside lag Theory

• Starting from point a, contractionary monetary
  policy shifts AD to left from AD0 to AD1
• In short run, real output and price level falls
  (a?b)
• In long run, real output returns to natural level
  Qn and price level falls further (b?c)
• How long does it take?

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Estimates of lag for US economy

• As predicted, when interest rates increase, GDP
  falls, then rises again
• The contractionary effect lasts at least two
  years, maybe more
• Different models give widely different estimates
• Lag for effect on prices (not shown) is even
  longer than effect on real GDP

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Estimated lags of contractionary policy in the EU

Charts show estimated impact of 1 percentage
point increase in interest rate according to
three different models. Changes shown relative to
price and output levels that would otherwise
prevail. Source ECB
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Steering the Monetary Ship

• Because of lags, conducting monetary policy is
  like steering a large ship
• After the captain turns the wheel, it takes a
  long time for the ship to change direction
• You must turn the wheel only a little at a time
  and wait for it to take effect
• If you turn too fast, there is a danger of
  oversteering

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The problem of forecasting errors

• If you are steering a ship, you are helped by an
  accurate chart
• If you see a rock on the chart, you can begin to
  turn the wheel when the rock is still far away
• Central bankers do not have an accurate chart of
  the future
• They are like a captain trying to steer a ship in
  the fog without a chart

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Example US GDP Forecasts

• Chart shows two-year growth rates for real GDP
  (actual and three forecasts for current and
  following year)
• Average error of actual GDP from mean forecast is
  .97 percentage points
• Average error of assumption that next years
  growth will be the same as this years is .94
  percentage points

Source http//angrybear.blogspot.com/2006/01/fore
cast-accuracy_24.html
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When lags and forecasting errors matter

• Cases where lags and forecasting errors do not
  cause big problems
• Seasonal variations in CUR forecasts are good,
  compensating changes in B have short lag
• Changes in RES or CUR due to shocks (e.g., 9/11)
  short inside lag, compensating changes in B have
  short outside lag
• Result Some sources of monetary instability can
  be controlled well

• Cases where lags and forecasting errors do cause
  big problems
• Velocity Long inside lag since it cannot be
  measured independently of GDP
• Real GDP, Q, and P Long inside and outside lags,
  difficult to forecast
• Result Impossible to achieve P or PQ target
  accurately in short term and difficult in medium
  term

Expanded equation of exchange (1CUR)/(RESCUR)B
V PQ
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Chronic instability in the US, 1961-1982

• The US economy from the 1960s to the 1980s saw a
  stop-go policy cycle in which each cycle hit
  higher inflation and unemployment rates
• This situation is often blamed on the combination
  of lags, forecasting errors, and time
  inconsistency

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What Central Bankers Cannot Do

• The notion that central banks can provide a
  low-cost, over-the-counter aspirin that will
  alleviate almost any ill that a society can face
  is no longer credible
• Robert Poole
• President, Federal Reserve
• Bank of St. Louis

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What can central bankers do?

• What can central banks do?
• Provide a stable framework for business planning
  by following rules that are announced in advance
• The rules should limit the risk that monetary
  policy actions will destabilize rather than
  stabilize the economy

• What rule?
• A gold standard
• A fixed exchange rate
• A money growth rule
• An inflation target
• A nominal GDP target
• A Taylor rule

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• Part 2
• A Gold Standard

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The Gold Standard in History

• In history, the most common monetary systems have
  been various forms of gold standard
• Used in the United States, United Kingdom, and
  other major countries until the 1930s
• Many central banks still hold symbolic reserves
  of gold
• How well does a gold standard serve the goal of
  monetary stability?

Money is too important to be left to central
bankers Milton Friedman
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Gold Standard in the 19th Century

• Price trend was downward on average in the US and
  UK
• Cause Supply of gold grew less rapidly than the
  economy
• Only serious inflation was in the US when paper
  money was issued during the civil war (1860s)
• Source IMF, Deflation Determinants, Risks and
  Policy Options, Findings of an Interdepartmental
  Task Force, April 2003

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Money Under the Gold Standard

• Forms of money
• Gold coins
• Banknotes that can be exchanged for gold
• Deposits payable in gold coin or banknotes

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The money multiplier under a F/R gold standard

• Let
• G monetary base stock of monetary gold
• COIN publics desired ratio of gold coins to
  bank deposits and notes
• RES ratio of bank reserves to bank deposits and
  banknotes
• The money multiplier is defined by the following
  equation
• MM (1 COIN)/(RESCOIN)

• Sources of monetary instability
• Changes in stock of monetary gold, G
• Changes in velocity, V
• Changes in demand for gold coins relative to
  deposits
• Changes in desired level of bank reserves

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Instability Monetary gold

• Factors favoring stability under a gold standard
• Government cannot manipulate the stock of gold
  for political gain
• Stock of gold changes only slowly over time
• Because hyperinflation is impossible

• Remaining sources of instability under a gold
  standard
• Bank runs from notes and deposits to gold coins
  could cause bank failures
• Shifts between monetary and non-monetary gold
  would change the monetary base
• Velocity may vary due to causes other than
  inflation

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Increasing stability with 100 Reserve Banking

• Concept
• Some sources of instability could be eliminated
  by eliminating fractional reserve banking
• Banks must hold gold equal to 100 of transaction
  deposits and banknotes
• Banks may fund loans by issue non-deposit
  liabilities without reserves

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Pros and Cons of 100 Reserve Banking

• Perceived advantages
• No bank runs
• Money Multiplier 1 regardless of public demand
  for gold coins
• Money stock changes only with gradual changes in
  G
• Nominal anchor equation
• GV PQ

• Unanswered questions
• Could banks fulfill their role as financial
  intermediaries?
• Would emergence of money substitutes increase
  velocity and undermine stability?
• Money-market mutual funds
• Sweep accounts
• Credit cards

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• Part 3
• Inflation Targeting

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Inflation targeting

• What is inflation targeting?
• Sets a target level for inflation over a time
  horizon of 1-2 years as the primary goal of
  monetary policy
• Retains flexibility in using a variety of policy
  instruments
• Emphasizes transparency and accountability of
  central bank performance

• Who has used it?
• New Zealand (1990)
• Canada (1991)
• UK (1992)
• Sweden (1993
• Finland (1993)
• Australia (1994)
• Israel
• Chile
• Euro zone

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Response to supply shock (1)

• Inflation targeting is sometimes criticized as
  too rigid in response to supply shocks
• Without targeting, supply shock, e.g. increase in
  energy prices, would move economy from a to b
• With strict zero-inflation target, AD would have
  to be reduced to AD1, with much larger loss of Q

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Response to supply shock (2)

• With rigid zero-inflation target, recovery to Qn1
  could occur only after decrease in non-energy
  prices and nominal wages shifted SAS downward
• Monetary policy could then be eased, shifting AD
  to AD2
• If labor markets were not flexible, this process
  could be very slow

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Response to supply shock (3)

• In practice, inflation targeting allows
  flexibility in responding to shocks
• Examples of flexibility
• Target over 1-2 yr period to allow for transient
  shocks
• Target core inflation (omit volatile prices like
  food, energy, and administered prices)
• Target a range of inflation, not a specific value
• Center the range on a value gt0
• Allow explicit deviation from target (rebasing)
  in case of a shock

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Response to productivity growth (1)

• Growth of productivity shifts LAS to the right,
  and shifts SAS down as production costs fall
• To maintain zero-inflation target, AD must shift
  to AD1
• Output will rise to Q2, greater than the new
  natural level Qn1

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Response to productivity growth (2)

• Shifting AD to AD1 requires real interest rate
  below their natural level
• Critics from the Austrian school fear asset
  bubbles and investment in projects that are not
  viable at natural real interest rate
• Shake-out of misplaced investment may cause
  recession

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Response to productivity growth (3)

• Instead of expanding AD to hold P constant, the
  Austrian school advocates holding AD constant
• Prices would fall as productivity increases
• Nominal wages do not have to fall, and real wages
  will increase
• Real interest rates remain close to natural level
  avoiding distortion of investment

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US Productivity in the 1990s

• During the 1990s, US productivity grew at its
  fastest rate in many years

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US Inflation in the 1990s

• The Fed held the inflation rate within a narrow
  band

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US Unemployment in the 1990s

• The unemployment rate fell steadily as actual
  real GDP grew faster than potential real GDP

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The technology bubble of the 1990s

• The resulting technology bubble was reflected
  in soaring NASDAQ stock prices. The collapse of
  the bubble was followed by the 2001 recession. In
  the neo-Austrian view, this episode shows how
  inflation targeting in the face of strong
  productivity growth can be destabilizing.

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A Nominal GDP Target?

• Advantages
• Uses both P and Q to absorb impact of adverse
  supply shock
• Need not trigger inflationary expectations if
  target is transparent and credible
• Allows moderate deflation in response to rapid
  productivity growth
• Limits danger of speculative bubbles and
  misdirected investment

• Disadvantages
• Long inside data lag and difficulties of
  forecasting nominal GDP
• Not easy for public to understand
• Political pressure may produce upward bias in
  projections of real output
• A reasonably flexible version of inflation
  targeting can capture the advantages while
  avoiding the disadvantages of nominal GDP
  targeting

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A Taylor rule

• Proposed by John Taylor, Stanford University,
  1993
• Sets provisional target for short-term nominal
  interest rates rt equal to historical average
  real interest rate rh plus desired rate of
  inflation pt
• Raises target rate by coefficient kgt1 when
  observed inflation rate p gt pt
• Raises target rate by coefficient g when observed
  output gap (Q/Qn)-1 greater than zero

• Example
• rh .02
• pt .01
• k 1.5
• g .2
• p .015
• (Q/Qn)-1 .05
• Calculation of interest rate target
• rt .02.01(1.5.005)(.05.2)
• 3 .0075 .01
• .0475

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Strengths and weaknesses of Taylor Rule

• Strengths
• Absolutely prevents hyperinflation and limits
  medium-term variation of inflation
• Provides transparent basis for business planning
• Removes danger of political manipulation of
  interest rates
• Approximately reflects actual behavior of US
  Federal Reserve during period of greatest success

• Weaknesses
• Does not eliminate problems of lags and
  forecasting errors
• Difficult to determine proper value of
  coefficients k and g
• If too small, may provide too little
  stabilization
• If too large, may oversteer
• May limit ability of central bank to react to
  unexpected shocks

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Proof that rules work or good luck?

The Fed has not adopted an explicit policy rule.
Nevertheless, the policy regime since the
mid-1980san implicit rule or constrained
discretionhas led to much better performance
than in earlier decades of the post-war period.
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Readings for Lecture 10

• Required readings
• William Poole, Monetary Rules? Federal Reserve
  Bank of St. Louis Review, April 1999
• Enzo Croce and Moshin Kahn, Monetary Regimes and
  Inflation Targeting, IMF, Finance and
  Development, September 2000
• Additional recommended readings
• Murray Rothbard, Taking Back Money, Ludwig von
  Mises Institute (reprinted from The Freeman,
  Sept/Oct 1995). A classic statement of the
  Austrian case for a gold standard.