Money and Banking Week 5

Chapter 15: Tools of Monetary Policy 1. Supply and demand in the market for reserves. a. The vertical part of the supply curve (NBR) shifts to the right and the federal funds interest rate declines. No effect emerges if the supply curve initially intersected with the hori ontal part of the demand curve. !. "t depends on the initial situation. See te#t!ook for the two possi!le scenarios. c. The demand curve shifts to the left and the federal funds interest rate decreases. No effect emerges if the supply curve initially intersected with the hori ontal part of the demand curve. d. This will increase the demand of reserves !y commercial !anks$ which will need to pay !ack deposits on demand. The result is a sharp increase in the federal fund rate. No effect emerges if the supply curve initially intersected with the hori ontal part of the demand curve. %. The fact that !anks do not want to lend to each other anymore means that the total demand for e#cess reserves goes up (some !anks now hold more e#cess reserves than !efore). To defend the federal funds rate target$ the central !ank should supply more reserves to the !anking sector to counter the upward pressure on the federal fund rate generated !y the increase in demand for reserves. The !est the central !ank can do is to target the !anks in need of reserves directly through its open market operations$ since the inter!ank market is not functioning in its usual way. &. See p. &'(. )uring the financial crisis$ the *ederal Reserve+ a. Set up additional lending facilities to provide li,uidity to parts of the financial system$ which e#panded reserves$ monetary !ase and total money supply. !. The increase in the supply of reserve caused the federal funds rate to decline !elow its target$ which the *ed prevented !y open market sales of securities in order to restore the original level of the federal funds rate (-sterili ation. of the lending operations). c. )ue to the large li,uidity in/ections$ the *ed risked to run out of securities (to use up its !alance sheet capacity) for open market sales. The interest rate on reserves puts a lower !ound on the federal funds rate close to the target rate$ such that the supply of reserves can e#pand without affecting the federal funds rate.

Chapter 16: The Conduct of Monetary Policy: Strategy and Tactics 1. The time inconsistency pro!lem is the ina!ility to follow a good long term plan consistently over time. This means that you have a plan of which you know that it will !ring you the !est possi!le results in the long run$ !ut in the short run you are tempted to deviate from it. 0n o!vious e#ample is monetary policy !y central !anks+ the long run plan is to have a sta!le policy aimed at keeping inflation low in the long term$ !ut in the short term it might !e tempting to have a policy that is more e#pansionary than people e#pect to !oost the economy in the short run. 1owever$ in the long run this will only give you higher prices and wages without any higher economic growth. The main strategies for central !anks to deal with this pro!lem are+ 2onetary targeting "nflation targeting 2onetary policy with an implicit nominal anchor *i#ed e#change rate policies 0ll these strategies have a nominal anchor in common$ which works as a commitment device and an e#pected constraint for the central !ank. "n order to !e successful they have to !e credible. This is the case the more independent a central !ank is. %. The !enefits of price sta!ility are well known are can !e summari ed in+ (1) improving transparency of relative prices3 (%) reducing inflation risk premia interest rates3 (&) avoiding unnecessary hedging activities; (4) reducing distortions of tax and social security systems; (5) increasing benefits of holding cash; (6) preventing arbitrary redistribution of wealth and income, and (7) contributing to financial stability. In general low and stable inflation is shown to lead to higher economic growth in the long run. Read carefully pages 56-57 of the ECB booklet to get an explanation of the single aspects. &. The e#act definition is+ -0 year4on4year increase in the 1"56 for the 7uro area !elow$ !ut close to$ %8. 6rice sta!ility is to !e maintained over the medium term.. Reasons for a positive level of inflation are+ Risks of deflation+ an inflation level of 98 can easily change into deflation$ which is very hard to fight for a central !ank. This risk is particularly large in 7urope$ since the inflation target is the average of all 7urosystem countries$ so for sure some countries are going to have a lower inflation than the average. Since you don:t want deflation in any of these countries$ aiming for a higher than ero average makes sense. ;age rigidity+ nominal wages are not easy to decrease in 7urope due to la!our union:s political power. To !e a!le to decrease real wages when this is necessary (for instance in an economic downturn)$ positive inflation is needed. 2easurement !ias+ official estimates of inflation usually overstate actual inflation. Since the inflation targets are !ased on official figures$ you should aim somewhat higher than your actual goal.

<. "n the long run the o!/ective of price sta!ility and high employment do not conflict with each other. "n that sense !oth approaches are valid. "n the short run focusing e#clusively on inflation may create e#cessive output fluctuations$ hurting employment$ so a sensi!le short term policy looks not only at inflation !ut also at other economic indicators. =n the other hand$ a dual mandate might !e used for overly e#pansionary monetary policy$ which is a strong argument for inflation targeting only. (. The !ig if is that monetary aggregates need to have a strong and sta!le relation with the economic varia!les you are targeting. 5entral !anks have stepped away from monetary targeting !ecause this link has !ecome weaker and more varia!le over time$ reducing the usefulness of monetary targeting as a strategy. 2oreover the monetary authorities are una!le to control precisely the monetary aggregates through changes in reserves or monetary !ase (see the pro!lems of the money multiplier model). >. 5hoosing the policy instruments. a. Reserve aggregates or interest rates$ not !oth$ !ecause you need to ad/ust the other to reach your target. See te#t!ook for a graphical illustration. !. The typical criteria that are used to choose an instrument are+ measura!ility$ controlla!ility and a!ility to affect the final goals. 0s far as the first two aspects are concerned reserve aggregates or interest rates are not superior to each other$ !ut nowadays 5Bs !elieve that the link !etween interest rates and inflation is tighter than the relationship !etween reserve aggregates and inflation (see pro!lems of monetary targeting a!ove). '. Taylor rule+ 0s we can see in the figure$ if the 75B would set its main refinancing rate target strictly according to the Taylor rule$ the 7=N"0 would have !een higher for the past ? years. This might indicate that the monetary policy in the euro area$ !eing too e#pansionary$ could have !een one of the factors underlying the financial crisis. 0t the same time$ movements in the Taylor rule and the 7=N"0 generally move in the same direction$ indicating that monetary policy pro!a!ly still followed the Taylor principle (raising nominal interest rates more than the rise in inflation). The fact that the 75B doesn:t precisely follow the Taylor rule may also indicate that the rule is too rigid to !e correct in all circumstances (for instance$ currently the 75B may !e more concerned a!out li,uidity positions of individual !anks than a!out inflation). The main advantages of the Taylor rule+ simple$ easy to communicate and still contains the growth and inflation dimensions. 2ain weaknesses+ not all possi!le influential factors are in it (e.g. li,uidity concerns$ the e#change rate$ the yield curve) and the coefficients may !e ar!itrary and in reality can !e e#pected to change (e.g. currently the output gap is pro!a!ly of larger relevance than the inflation gap).

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1999Q1 1999Q4 2000Q3 2001Q2 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 1996Q1 1996Q4 1997Q3 1998Q2 2002Q1 2002Q4 2008Q1 2008Q4 -1.0 -2.0 2009Q3 EONIA Taylor

@. There are two kinds of asset price !u!!les$ credit4driven and e#pectations4driven. The e#pectations driven !u!!les are very hard to identify so monetary policy can not react to them. 5redit4driven !u!!les are easier to identify and can cause a lot of damage$ so a central !ank may want to respond to these. Asing monetary policy may not !e the !est option for responding to a !u!!le$ !ecause 1) the effect of raising interest rates is uncertain$ %) monetary policy is a very !lunt tool for reacting to !u!!les and &) using monetary policy in this way may have other negative effects. Supervising financial institutions may !e a more appropriate course of action for central !anks to try to prevent asset price !u!!les. ?. The latest press release of the &rd of Novem!er %911 stated+ PRESS RELEASE 3 November 2011 - Monetary policy decisions At todays meeting the Governing Council of the ECB took the following monetary policy decisions: ! The interest rate on the main refinancing operations of the Eurosystem will be decreased by "# basis points to !"#$% starting from the operation to be settled on & 'ovember "( ! "! The interest rate on the marginal lending facility will be decreased by "# basis points to "!(($% with effect from & 'ovember "( ! )! The interest rate on the deposit facility will be decreased by "# basis points to (!#($% with effect from & 'ovember "( !

The *resident of the ECB will comment on the considerations underlying these decisions at a press conference starting at "!)( p!m! CET today! )uring the 6ress 5onference$ which can !e downloaded in http+BBwww.ec!.intBpressBpressconfB%911BhtmlBis11119&.en.html$ the president of the 75B 2ario )raghi stressed the following points+ a) The reason for the reduction of interest rates is that the 75B thinks that - while inflation has remained elevated and is likely to stay above "$ for some months to come% inflation rates are e+pected to decline further in the course of "( " to below "$! . These downside risks to price sta!ility are mostly linked to the high degree of uncertainty. Reading the statements you will clearly see the two4pillar monetary strategy of the 75B. !) "n the latest statement$ there was no mention to the Creference value: for 2& growth. 1owever$ consistently with the monetary4analysis pillar$ the 75B provides an assessment of the most recent dynamics in 2& growth and its counterpart side (e.g. growth of loans to non4financial corporations and to households). =n the !asis of the Cmoderate: developments on !road money and loan growth$ the 75B seems to provide convincing arguments to /ustify a reduction of the key interest rates. ;hether or not the presence of a money pillar is fully /ustified is (and will !e) open to discussion. "t is however true that the monetary pillar$ is potentially more useful (than the economic pillar) to assess the presence of asset price cycles and their implications for financial sta!ility. The latter is another goal of central !anks that will for sure increase in importance over the coming years.