guest lecture Flashcards
Real interest rate
=nominal interest rate minus expected inflation rate
monetary tightening = restrictive policy
requires central
banks increasing policy rates more than increases in expectedinflation.
- Central banks can only determine
(very) short-term interest rates
Economic decisions are primarily affected byβ¦.
long-term interest rates(think of mortgages, corporate loans)
Long-term rates (partly) reflect
expected future short-term rates
Delay or insufficient increase in current policy rates will imply
bigger increasein CURRENT and future longer-term rates (due to higher inflation
expectations) which implies a sharper negative effect on economic growth
- Conventional:
using prices (interest rates) as the primary instrument.
Works as long as interest rates are not substantially negative
- Unconventional:
using quantities as the primary instrument:
CB transactions of financial assets, usually government bonds
* CB asset purchases are financed by liquidity that is created our of nothing (!)
* This additional liquidity greases financial markets and (hopefully) the real economy.
* It works symmetrically: CB selling gov. bonds reduces market liquidity
Goal monetary policy
price stability: inflation rate of 2% to be achieved in the medium term. CB focuses on general price level, not relative prices andignores temporary movements in general price level.
- On impact, the energy price hike is a what price change
relative
In a frictionless world there is no impact on the general price level because
nominal prices of other products decline, leaving price level unchanged
* π = ππe + (1 β π)π0
However, prices are sticky
do not adjust immediately
and are rigid
eg due tocontracts, menu/transaction costs, economic slack)
So a relative price change can be a
source of inflation (change in general pricelevel)
Direct effect
consumers of final energy products
confronted with increasing prices of energy (eg our heating bill)
Indirect effect=
: higher energy prices feed intoproduction chain: higher costs of energy as intermediate input pass
through into consumer prices of other goods and services (eg air fare).
- Alternative pass through mechanism:
higher inflation feeds into higherwages >
wage-price spiral
3 types of energy price hikes
temp spike
perm jump
perm rise
temp spike
perm jump
perm rise
Alternative transmission channel of energy hike:
Wage-price spiral
- When an (energy) price increase leads to higher wage demands of
employees leading to higher wages leading to higher wage costsfirms, and (ultimately) higher prices. - Higher prices induce more wage hikes, leading to higher prices etc* Corporate sector confronted with erosion of profitability, erosion of
competitiveness leading to lower investment, lower economic
growth, unemplosyment. Example: 1980
STAGFLATION
permanently higher inflation rates and lower economic
growth:
RESULT OF WAGE PRICE SPIRAL
- DEMAND management:
Influencing AD line
* Budgetary (fiscal) policy
* Monetary policy
- Goal=influencing the business cycle: aimed at the short/medium run* Can have (perverse) long run effects.
ECONOMIC DIAGNOSIS OF ENERGY CRISIS
- Negative aggregate supply shock
- Impact: higher prices, lower output
- Simple textbook solution: counter negative supply shock with positiveshift in demand
PROBLEMS WITH NEGATIVE SUPPLY SHOCK
- Lower output and higher price level
- Expansionary budgetary policy increases gdp but also prices
- Persistent higher inflation requires restrictive monetary policy which reducesinflation and gdp
- Either monetary policy accepts higher price level, possibly violating its
mandate, or reacts and budgetary policy effects will be reduced (why???) - CB accepting higher price levels might induce more cost increases (higherwages due to higher inflation expectations) implying further negative supplyshock (wage price spiral) and permanently higher inflation
financial stability andprice stability
AS: cost of (production factor) capital. AD: wealth effect, availability of credit,
housing.
* Asset prices, credit creation and balance sheets important: are financial conditionssustainable? Balance sheet recession.
Financial conditions make economies more
procyclical
procyclical
more intensive
booms, but also more intensive busts.
- Higher inflationary pressures alongside elevated financial vulnerabilities,
specifically high indebtedness and surging house prices
s= risky: output costof tighter financial conditions could be larger than in the past
The funding of expansionary budgetary policy might create financial instability in the form of
Tax hikes, expenditure cutbacks, debt issuance
Recent example UK: Financial vs Price stability
- High indebtedness consumers, firms and governments makes market liquidityvery important (determines ability to refinance debt)
- BoE (as most CBs) in tightening mode, selling government bonds and reducingliquidity in the market in order to combat inflation
- Reduced market liquidity implies larger volatility and more impact of fire sales* UK: fiscal plans Tuss government reduced market confidence in government bonds: decrease in price and sharp increase bond yields
- Liability driven investment strategy UK pension funds caused huge losses on theirderivative positions, eliciting large margin calls and dash for cash, leading to firesales
- Downward spiral. Risk to FS
- BoE forced to intervene: buying bonds, providing market liquidity
- This contradicts its tightening mode: inflation requires less liquidity
Role of monetary policy (in general)
- CBβs mandate is to deliver low and stable inflation. This enables people todistinguish between general and relative price changes (improving allocation)
- But also responsibility for economic growth (although in varying degrees)
why is monetary policy on the lookout for signs of second roundeffects:
: higher energy prices becoming engrained in the behaviour of economic agents leading to (cost increases and) persistently higherinflation expectations.
example of second round effects
indexation
what do second round effects imply
unhinged inflation expectations and thiswill elicit a tightening of monetary policy
The problem with supply shock: monetaryfiscal policy mix
Fiscal expansion and monetary tightening ο¨tension
* Pressure on central banks to delay tightening
* But delay might imply higher long-term rates (why?) and more output loss
* And higher long-term rates reduce the effects of fiscal expansion* Correct diagnosis in real time of type of price shock crucial but
difficult
* Incorrect diagnosis has serious macroeconomic consequences
covid
Exogenous shock
* Loss of lives
* Loss of productive capacity
* Breakdown of global value chains
* Both demand and supply negatively affected (why??)
* Substantial income support by governments
* On top of secular demographic developments (ageing)
* ο¨ economies operating at capacity.
Energy crisis (2022-?)
- Political origin: reaction to Putinβs invasion of Ukraine
- Putin uses natural resources (oil and LNG) as a political weapon.
- This crisis came at a time we were still recuperating from earlier
problems (see earlier slides) - This has a bearing on resilience and (in some countries) availablepolicy space (room to maneuvre)
- Massive income support by government impacted public finances
- Massive monetary support from unconventional policies led to loose financial conditions (low rates, massive liquidity, high indebtedness)
- Economies were operating at capacity
Policymakers should constantly assess their policy measures along three dimensions:
Necessity
effectiveness
side effects
Necessity
- Monetary policy tightening required by mandate because of evidence of second round effect of energy price hike on costs and inflation (see graphs)
- Necessity expansionary budgetary policy depends on objective policy (income support, energy transition, β¦)
- Expansionary budgetary policy may be required for supporting some consumers and firms (micro economic perspective)
effectiveness
- History: Restrictive monetary policy is effective in combatting inflation. Macro-economic instrument for a macro-economic
problem. Clear mandate of CB. - Budgetary policy can be effective if directed towards targeted groups. Is however difficult to make operational and politically sensitive.
- Multiple objectives of budgetary policy reduce its effectiveness:
Supply side strengthening? - The tension between expansionary budgetary policy and restrictivepolicy implies reduced effectiveness of both types of policy. Need forpolicy consistency. IMF (2022).
side effects
Monetary policy: can contribute to financial instability. Current financial
fragility makes it difficult to fine-tune the output effects of monetarytightening.
* Expansionary budgetary policy may shield the economy from the relativeprice change that is crucial for transitioning to a less energy intensive
economy
* Expansionary budgetary policy reduces the public funds available tocounter longer term challenges such as sustainability (greening) anddemography
