1. Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague JEM027 Monetary Economics Monetary policy implementation and money supply in normal times Tomáš Holub Tomas.Holub@cnb.cz October 12, 2015

2. JEM027 – Monetary Economics 1 ▪ Does the central bank control money supply? ▪ Does the choice of MP regime matter for this? ▪ How is MP implemented in normal times? ▪ How should central banks set the interest rates? ▪ Simple vs. complex interest rate rules – what is better? Basic questions

3. JEM027 – Monetary Economics 2 Money supply is controlled by the central bank A Don’t know C B Money supply (endogenously) reflects the economic developments Introductory quiz (1/2)

4. JEM027 – Monetary Economics 3 ST interest rate is controlled by the central bank A Don’t know C B ST interest rate (endogenously) reflects economic developments Introductory quiz (2/2)

5. JEM027 – Monetary Economics 4 ▪ CB controls monetary base (OMO) ▪ Stable or predictable money multiplier ▪ Key assumption: stable or predictable free reserves i M/P MSMS MDMD OMO Monetary base Money supply (target) Inflation (+output?) (goal) Textbook (monetarist) approach with exogenous money

6. JEM027 – Monetary Economics 5 i M/P MDMD MSMS ▪ CB supplies liquidity at the given interest rate ▪ Weintraub: political motive (when wages and prices start growing, CB does not want to create recession, and thus prefers to increase M) ▪ Kaldor: CB acts as the lender of the last resort, supplying liquidity elastically at a given interest rate ▪ Endogenous velocity (effective money supply is M*V; financial innovations move V) Post-Keynesian approach

7. JEM027 – Monetary Economics 6 ▪ Exogeneity or endogeneity is not a physical characteristic of money ▪ It may depend on the length of the period (short-term vs. medium-term) ▪ It crucially depends on CB‘s monetary policy and operational regime A debate of the past?!

8. JEM027 – Monetary Economics 7 Example: fixed ER regime ▪ With fixed exchange rate, money supply clearly becomes endogenous ▪ When international mobility of capital is perfect, liquidity is supplied with infinite elasticity at the world interest rate ▪ Mundell-Fleming model i M/P i* MDMD

9. JEM027 – Monetary Economics 8 ▪ In the short-run, demand for liquidity may be volatile and rather inelastic ▪ Fixing the monetary base leads to large IR volatility ▪ Costly in terms of stability of real economy, financial stability and IR predictability ▪ Paul Volcker‘s period in the USA (1979-82; “non-borrowed reserves operating procedure”) ▪ “Borrowed-reserves operating procedure” since then i M/P MDMD MSMS Problems with monetary base operational procedure

10. JEM027 – Monetary Economics 9 … IS … LM … better to fix IR (implies lower y t variability); if h is small, the inequality is more likely to hold Recall W. Poole (1970)

11. JEM027 – Monetary Economics 10 JEM027 – Monetary Economics ▪ IR as the operational tool ▪ Volume of the OMOs (or other liquidity-providing or sterilizing operations) is set based on the estimate of demand ▪ Deposit and lending facility define a corridor for acceptable short-term IR fluctuations ▪ No motivation for banks to keep much free reserves ▪ Liquidity is endogenous, at least in the short-run ▪ In a longer-run: it depends on CB reactions (i.e. its policy regime) i M/P MDMD Main refinancing rate Lending facility Deposit facility Modern operational regime

12. JEM027 – Monetary Economics 11 JEM027 – Monetary Economics Czech interest rates ▪ Usually negligible deviations of short-term PRIBOR rates from 2W repo rate ▪ Currency crisis in 1997 was an intentional exception ▪ Normally a corridor of ±1 p.p. (discount and Lombard rate), in line with ECB‘s regime (until the global crisis period)

13. JEM027 – Monetary Economics 12 JEM027 – Monetary Economics ▪ CB may react with IRs to target the money supply ▪ Money may thus behave in an exogenous manner in the medium run ▪ However, most CBs do not target money supply (see the demand-for- money lecture), but something else – e.g. inflation targeting i M/P i MDMD MD‘MD‘ i’i’ But: money could still be exogenous-like

14. JEM027 – Monetary Economics 13 JEM027 – Monetary Economics Differences in detail ▪ E.g. Fed funds target rate vs. ECB‘ refinancing rate ▪ Liquidity-providing operations (ECB traditionally) vs. liquidity-withdrawing operations (CNB) ▪ Full-allotment fixed-rate tenders (Canada, Hungary, ECB now) vs. variable-rate tender (CNB, ECB normally) ▪ Different maturity of operations (ON, 2W, 3M, …) ▪ Different definitions of eligible counterparties and collateral ▪ Different width of the corridor around the main rate, etc. The details of MP implementation differ among CBs

15. JEM027 – Monetary Economics 14 JEM027 – Monetary Economics ▪ Offers a simple presentational tool ala IS-LM, AD-AS ▪ More realistic monetary policy description ▪ CB sets real interest rate (it sets nominal IR, which determines real IR given the inflation persistence) r Y MP(π) IS Y* Source: Romer D. (2000): “Keynesian Macroeconomics Without the LM Curve”, WP No 7461, NBER (http://papers.nber.org/papers/w7461) Keynesian economics without LM curve (Romer)

16. JEM027 – Monetary Economics 15 JEM027 – Monetary Economics Price level indeterminacy (1/2) ▪ Sargent – Wallace (1975): IR-rules lead to price level indeterminacy in models with rational expectations ▪ For a given i, equations (1)-(3) determine y, r, π ▪ Equation (4) determines m-p only; money supply may endogenously adjust to any level of prices … IS … LM … PC(1) (2) (4) (3)

17. JEM027 – Monetary Economics 16 JEM027 – Monetary Economics Price level indeterminacy (2/2) i M i CB M D (Y,P 1 ) M1M1 M D (Y,P 2 ) M2M2 ▪ An equilibrium for the interest rate set by central bank and with the same real GDP and inflation is achieved both for (P1;M1), and for (P2;M2) – or in principle for an infinite number of combinations of P and M ▪ Thus the price level is indeterminate ▪ But: McCallum (1981): this is true only for “pure interest rate pegs” (IR path exogenous, not responding to endogenous variables)

18. JEM027 – Monetary Economics 17 JEM027 – Monetary Economics Taylor rule (1993) Federal funds rate and example policy rule ▪ “Discretion vs. policy rules in practice” ▪ Describes systematic component of policy ▪ But room is left for judgment (discretion) ▪ Shown to fit the US Fed funds rate quite well ▪ Specification in line with the Fed‘s dual mandate

19. JEM027 – Monetary Economics 18 JEM027 – Monetary Economics Taylor principle (i) ▪ If c=0, b must be higher than 1 ▪ Intuition: if b<1, a shock which raises inflation lowers the real interest rate, this increases output, which further raises inflation, lowers the real IR… ▪ Therefore, real interest rates must increase with higher inflation ▪ Note: too strong reactions may be a problem, too r Y IS M1M1 IS‘ Y* r* (π*)

20. JEM027 – Monetary Economics 19 JEM027 – Monetary Economics Taylor principle (ii) ▪ If b>1, real interest rate is increased after an inflationary shocks ▪ This pushed the output down (in this case closer to equilibrium) ▪ Once the output gap is closed, it causes no further upward pressure on inflation r Y IS M1M1 IS‘ Y* r* (π*) r* (π‘)

21. JEM027 – Monetary Economics 20 JEM027 – Monetary Economics Alternative rules MP rules Backward-lookingForward-looking SimpleOptimal Optimized coefficients Calibrated coefficients Estimated coefficients Estimated coefficients

22. JEM027 – Monetary Economics 21 JEM027 – Monetary Economics Optimal MP rules ▪ Interest rate reacts to all pieces of information (all state variables) ▪ Coefficients found to minimize the expected value of the loss function ▪ Problems: very complex, individual coefficients sometimes counter- intuitive, difficult to explain, may not be robust var(inflation) var(output)

23. JEM027 – Monetary Economics 22 JEM027 – Monetary Economics Optimal rules – example (1/2) Source: Svensson, L. E. O. (1998): “Open-Economy Inflation Targeting.” London, CEPR Discussion Paper No. 1989 (October). Reaction function coefficients

24. JEM027 – Monetary Economics 23 JEM027 – Monetary Economics Optimal rules – example (2/2) Source: Hlédik, T. (2003): “Modelling the Second-Round Effects of Supply-Side Shocks on Inflation.” WP CNB 12/2003. (http://www.cnb.cz/www.cnb.cz/en/research/cnb_wp/download/wp12-2003.pdf) Model solution with the wage contracting equation based on CPI

25. JEM027 – Monetary Economics 24 JEM027 – Monetary Economics Forward-looking Taylor rule ▪ Used in many models (including models of CBs) ▪ Inflation forecast reflects all available information ▪ But the rule is much simpler, easy to communicate ▪ With optimized weights, it may get reasonably close to the optimal rule, and at the same time be more robust ▪ Optimal policy horizon: see Batini – Haldane (1999) ▪ Policy inertia: may reflect policy preferences, uncertainty, etc.

26. JEM027 – Monetary Economics 25 JEM027 – Monetary Economics Fed‘s reaction function

27. JEM027 – Monetary Economics 26 JEM027 – Monetary Economics Some suggestions to extend the Taylor rule ▪ Add the exchange rate for small open economies? (e.g. L. Ball, 1998, http://www.rba.gov.au/rdp/RDP9806.pdf) ▪ Add the credit growth or some other financial variable? (e.g. IMF, WEO, October 2009, chapter 3; http://www.imf.org/external/pubs/ft/weo/2009/02/pdf/c3.pdf) ▪ Include asset prices (e.g. housing prices) in the targeted price index or separately?

28. JEM027 – Monetary Economics 27 JEM027 – Monetary Economics Conclusions Optimal rules may be difficult to interpret and communicate, and not sufficiently robust 5 1 One cannot a priori say, if money supply is controlled by the central bank, it critically depends on the MP regime 2 Modern MP regimes lead to endogeneity of money (but this does not mean that the post-Keynesian view was correct, especially as regards ineffectiveness of MP) 3 In normal times, most CBs with autonomous MP control the short-term interest rates 4 MP must react sufficiently to stabilize the economy and inflation expectations (the Taylor principle) Forward-looking Taylor rule often used in practice (with some controversial suggestions to add further variables) 6