1. 1 Stabilising the economy: Central Banks and Monetary Policy Topic 4 MSc EPs Hilary term 2011 Professor Dermot McAleese

2. 2 Aim of economic policy is to reduce volatility of market economy time GDP GDP with counter-cyclical policy time GDP without counter-cyclical policy Potential GDP

3. 3 PRICE STABILITY AND THE CENTRAL BANK  Price stability defined  Why is price stability important?  Role of Central Bank  Monetary policy – objectives and instruments  Effectiveness of monetary policy

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5. 5 Price Stability  a rise in the general level of prices below, but close to, 2% over the medium term (ECB May 2003)  Consumer Price Index (CPI)  Sources of measurement bias  Composition bias  Quality bias  Substitution bias Note: Should asset prices be included in CPI?

6. 6 WHAT CAUSES INFLATION? Inflation is always and everywhere a monetary phenomenon (Friedman)  Demand shocks (property price boom)  Supply shocks (oil, energy price increase)  Budget deficit  Money supply

7. 7 WHAT CAUSES DEFLATION? Demand shocks (property price fall; stock exchange collapse) Supply shocks (interest rate increase) Budget surplus Money supply – credit reduction

8. 8 ECONOMIC COSTS OF DEFLATION (DMcA pp 284-286)  Inefficiency effects  Redistributive wealth effects  Adverse dynamics – deflationary spiral  Costly to restore price stability

9. 9 Fisher’s Paradox The more debtors pay, the more they owe. (the chief secret of most if not all great depressions)

10. 10 JAPAN’S DEFLATION (Box 12.1 pp 290- 291)  Land prices and commercial property fall by 50% 1990- 1995. Commercial estate prices fall 87% in real terms (Koo, 258)*  Nikkei index falls from 38,900 in 1989 to under 10,000 (just over 7.000 in March 2009)  Consumers prices decline  “Adverse dynamics” dominant  Combination of debt and deflation ‘a lethal cocktail’. Balance sheet recession  ‘Zero interest floor’ problem * Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 2009

11. 11 Source: CPI data, taken from World Bank, OECD

12. 12 TASKS OF CENTRAL BANK  Monetary policy  Lender of last resort -- preservation of financial system ------------------------------  Exchange rate defence  Manage official foreign reserves  Government banker

13. 13 THE CENTRAL BANK Price stability – ultimate objective Intermediate targets  Money supply  Inflation ‘lead’ indicators  Exchange rate Employment, economic growth?

14. 14 Objective European Central Bank (ECB) Primary objective of the Eurosystem is to maintain price stability.

15. 15 TASKS of Federal Reserve Bank Objective is “to attain maximum employment, stable prices and moderate long term interest rates”.

16. 16 Euro Area’s Money Supply June 2009 (€bn) Currency in circulation Overnight deposits Narrow Money (M1) Short-term Deposits (Quasi-Money) Money Supply (M3) 735 3,505 €4,240 5,190 €9,430bn Memo: GDP 2008 = €9,200 bn Source: ECB Monthly Bulletin M3 at june 2010 is €9,419 bn ECB Sep 2010

17. 17 ACHIEVING PRICE STABILITY  Political commitment  Institutional framework  Independent Central Bank  Clear policy objective  Fiscal sustainability

18. 18 European Central Bank (ECB) Neither the ECB, nor a national central bank, nor any member of their decision- making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body.

19. 19 POLICY INSTRUMENTS OF CENTRAL BANK Open market operations Interest rate Minimum reserve ratio ----------------------------------------- Intervention in forex markets Direct controls -------------------------------------------- Unconventional measures DMcA pp318-333

20. 20 BanknotesNo of notes (m) Value (€bn) €51,300 6 €102,00020 €202,25045 €504,500220 €1001,200120 €200 15030 €500 480240 Euro banknotes in circulation December 2007 ( €677bn) Source: computed from ECB Annual Report 2007

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22. 22 ECB: main refinancing rate BoE: official bank rate Fed: target rate

23. 23 EEAG report feb 2010 (updated)

24. 24 INTEREST RATES AND ECONOMIC ACTIVITY (pp 315-318) THE MONETARY TRANSMISSION MECHANISM

25. 25 MONETARY POLICY AND REAL GDP 1.Substitution effect (-) i  (-) Saving, (+) Consumption 2. Cash flow (income) effect (-) i  (+) cash flow of borrowers (-) i  (-) cash flow of lenders 3. Wealth effect (-) i  (+) in value of property and equities  (+) Consumption  (+) Investment 4. Cost of Capital (Investment) effect (-) i  (+) Investment

26. 26 MONETARY POLICY AND REAL GDP 5. Exchange rate effect (-) i  depreciation of real exchange rate 6. CB credibility effect (-) i  (+) domestic confidence

27. 27 Relax monetary policy Higher money base Lower interest rate Growth in private sector credit More spending Consumer price increase Asset price boost? More output in short run Price stability and economic recovery More at work Fig 13.6 p 321 HOW MONETARY POLICY COMBATS DEFLATION

28. 28 If actual output > potential output, restrictive monetary policy will reduce dangers of inflation Objective is to secure a soft landing ….

29. 29 If actual output < potential output, expansionary monetary policy will reduce danger of deflation Objective is to secure price stability… Need for reflation, or “mild” inflation to solve private debt trap?

30. 30 Limitations of monetary policy Nominal interest rate cannot go below zero (ZIRP) When prices are falling, real interest rate can stay high even as nominal rate falls Monetary policy encourages spending but cannot make it happen

31. 31 1.Define price stability. Why is attainment of price stability important? 2.What policy actions can a central bank take to prevent deflation? 3. Can the use of monetary policy on its own cure a recession? What are the limits to its effectiveness? 4.Q 3 p. 303 --- does business prefer rising prices to falling prices? 5.What actions if any should the ECB take to reduce the Euro area’s high unemployment rate? Questions for Group work

32. 32 You can tell whether a man is clever by his answers. You can tell whether a man is wise by his questions. Naguib Mahfouz Nobel Prize for Literature 1988

33. Exercise 5 p. 332 During 2003-4, as nominal interest rates fell to near zero, there was much discussion of the need for central banks to have recourse to ‘unconventional measures’ in order to stimulate aggregate demand. These measures included: a)Direct increases of the monetary base b)Purchase of corporate debt c)Purchase of government bonds to reduce long term interest rates d)Buying private securities to boost asset prices e)Explicit commitment to higher inflation target of 3 per cent. Analyse how each of these measures might be expected to impact on aggregate demand.

34. 34 CONCLUSIONS  Price stability is good for economic growth  Deflation is just as damaging as inflation  Aggressive monetary policy required to prevent deflationary adverse dynamics taking hold  In times of crisis monetary policy not enough on its own. Expansionary fiscal policy also needed

35. 35 G20 COMMUNIQUE LONDON APRIL 2009 Monetary Policy in Action

36. 36 Monetary Policy not enough …. …….. in current conditions monetary policy will be insufficient. This is a Keynesian situation that requires Keynesian remedies. Budget deficits will end up at levels previously considered unimaginable. Martin Wolf Financial Times Wed 22 Oct 2008

37. 37 OECD Economic Outlook Nov 2009 p. 38