WEEK VIII Central Bank and Monetary Policy

W EEK VIII Modern monetary policy: inflation targeting Costs of inflation: Shoe-leather costs:    i  : cost of holding money  Money illussion: real vs nominal term of payments (e.g. income, interest rate) Tax distortions: tax is charged based on nominal instead of real payments Inflation variability: create uncertainty Benefits of inflation: Seignorage: borrow less from public or to lower taxes The option of negative r: economy with a higher inflation rate has more room to use monetary policy (i.e. reducing i) to fight recession before it hits the liquidity trap Money illusion and real wage adjustment: people will accept the real wage cut due to an increase in inflation rate instead of a reduce in nominal wage

W EEK VIII Design of Monetary Policy Until the early 1990s: targeting nominal money growth rate (e.g. M1 or M2) for the medium run and short-run monetary policy in terms of deviations of nominal money growth from that target. A close relation between inflation and nominal money growth in medium run (recall: the neutrality of money) In the 2000s: targeting inflation rate for the medium run and short- run monetary policy in terms of movements in the nominal interest rate. The relation between inflation and nominal money growth is not tight enough due to shifts in the demand for money such as the introduction of credit cards Nominal money stock remains constant (or money growth = 0) but inflation rate > 0)

W EEK VIII Inflation targeting is not exclusively focusing on inflation but also would lead the central bank to eliminate all deviations of output from its natural level: Phillips curve: Where  * is inflation rate target, when the central bank could achieve the target then u t = u n. When AD    <  * : monetary expansion to avoid recession When AD    >  * : monetary contraction to avoid overheating

W EEK VIII Design of monetary policy in Indonesia 1.Prior crisis 1997/1998: Multiple objectives: low level of unemployment, high economic growth, a sustainable balance of payment and a tolerable inflation rate Policy target: money supply. By controlling money supply will affect real interest rate (in money market or affect LM curve) Tools: Reserve requirement, open market operation (SBI and SBPU) 2.Post crisis 1999: One single objective: to establish and maintain rupiah stability that incorporates 2 key aspects: 1.A stable rupiah for goods and services (i.e. purchasing power of rupiah), reflected by the inflation rate. 2.In term of exchange rate stability against other foreign currencies, which is reflected by rupiah performance against other foreign currencies

W EEK VIII 2.Post crisis 1999 (continued) Policy target: interest rate. BI rate provide signal to influence money market rates (i.e. SBI and SPBU rates) and in turn the deposit rates and lending rates in the banking system. Changes in these rates will ultimately influence output and particularly inflation rate (i.e. AD-AS Model). Tools: BI rate set by BI

W EEK VIII Indonesian monetary transmission mechanism

W EEK VIII Interest rate rule Inflation rate is no under direct control of the central bank The central bank affects spending through the interest rate The central bank then should follow a rule to set the interest rate ( Taylor rule) Where: i t is the nominal interest rate controlled by the central bank (i.e. BI rate), i* is the target nominal interest rate (associated with  *),  t is the rate of inflation (as measured by the GDP deflator),  * is the target rate of inflation, u t is the unemployment rate, and u n is the natural rate of unemployment. a and b are positive coefficients Interpretation:  t =  * and u t = u n, the central bank should set i t = i*  t >  *, the central bank set i t > i*. The increased interest rate will increase unemployment rate and will lead to a decrease in inflation.

W EEK VIII The increase depends on the coefficient a. the higher a, the more the central bank will increase interest rate in response to inflation, the more unemployment will increase. a > 1 because what matters in spending is the real interest rate instead of nominal interest rate When inflation increases, the central bank must increase the real interest rate, or increase nominal interest rate more than one-for-one with inflation. U t > u n, the central bank should decrease the nominal interest rate. The decrease depends on the coefficient b. the higher b the more the central bank willing to deviate from target inflation to keep unemployment close to the natural rate.

W EEK VIII Challenges for monetary policy: 1.The liquidity trap: prevent the central bank to decrease the interest rate (thus fail to stabilize economy) e.g. Japanese economy A monetary expansion (the shift from LM1 to LM2) has no effect on equilibrium interest rates or output.

W EEK VIII Avoiding the liquidity trap: to have higher inflation rate (target).    i  then have more room to i . Getting out the liquidity trap: to have higher expected inflation.  e   r  (0 -  e )  I   AD   Y  Quantitative easing: how the central bank affect inflation expectation 2.Stable inflation is not a guarantee of macroeconomic stability due to problem in the housing and financial sectors in US (bubble vs fundamentals) Macro prudential regulation: risk assessment of borrowers and lenders Loan o value ratio (LTV): ratio of a loan to the value of an asset purchased. The higher the LTV ratio, the riskier the loan is for a lender Implementation of Basel I, Basel II and Basel III: Credit risk, market risk and operational risk