5 - Monetary Policy

Question 1

There are two conditions for monetary policy to succeed in controlling inflation.

Answer 1

1. CB must control the chosen monetary aggregate.
2. The relationship between the monetary aggregate and inflation must be stable.

If either of these conditions don’t hold, CB credibility will be low.

Question 2

Failure of monetary targeting - Thatcher

Answer 2

•Thatcher gov. targeted the growth of broad money, M3
-the early 1980s would see substantial shifts in demand for money
•they missed targets for M3
•changes in economic policy, financial innovation and the severe economic downturn had changed the relationship between M0 and M3, leading to the gov. losing control of M3

Question 3

Monetarism - keep money supply fairly steady

Answer 3

Thatcher’s gov. accepted a high sacrifice ratio in terms of unemployment to get inflation down.
Her speech advocates monetary policy and stressed their commitment to achieve the inflation target
-anchoring

Question 4

Asset price bubbles

Answer 4

An asset price bubble occurs when the price of an asset far exceeds its economic fundamentals.
Eg. Dot com boom, property

Question 5

Asset price bubbles are seen as undesirable because they:

Answer 5

• distort resource allocation and relative prices

* can cause financial instability, deviations of inflation from target, and output from equilibrium

Question 6

Whether a CB should step in to burst an asset price bubble in their early stages depends on three main elements:

Answer 6

1. Being able to identify bubbles before financial markets.
2. Refraining from identifying bubbles that do not exist.
3. Bursting bubbles without causing excessive damage to the wider economy.

It is debatable whether CB’s can correctly identify bubbles.
If they are able to do so, they are best dealt with by macro-prudential regulation.
-interest rates are a blunt instrument

Question 7

Compare conventional monetary policy with QE.

Answer 7

QE has five transmission channels, as opposed to one clear transmission mechanism with conventional monetary policy:

1. Confidence - public’s perception of economic outlook
2. Policy signalling - aids CB in anchoring inflation target
3. Portfolio rebalancing - long term interest rates fall
4. Market liquidity - actively encourage trading
5. Money - sellers of gov. bonds to CB will be left with cash

Question 8

QE: is it dangerous?

Answer 8

QE did imply a rapid expansion of CB’s balance sheet.
- a bigger balance sheet results in greater risks for the CB

Other dangers include:

1. CB’s independence and credibility: political areas, reduction in credibility leads to less firm anchors to inflation target.
2. QE raises asset prices above fundamentals which may fuel future asset price bubbles.
3. Excess reserves - can fuel a new lending boom
4. Exit: QE not unwound when CB stops purchasing assets, but when assets mature or sold back onto market