Monetary policy

Question 1

What do we mean by ‘money neutrality’?

Answer 1

Changes in the money supply only affect nominal variables, rather than real variables (unemployment levels, real GDP, real prices etc)

If the government expands the monetary base, there should be a proportionate increase in the price level (inflation)

Question 2

Why might money neutrality not hold?

Answer 2

Short term impact of price stickiness and imperfect information - e.g. menu costs

Question 3

What do we mean by ‘superneutrality of money’?

Answer 3

Changes in the rate of money supply growth have no effect on real variables - although a rise in the growth of money will increase inflation and change the nominal interest rate, and since real = nominal - inflation, real interest rates will likely change too

Question 4

What are the channels through which QE should affect the economy? [5]

Answer 4

1) Policy signalling - raises the price level, leads to inflation, signals commitment to target
2) Portfolio rebalancing - increased demand for government bonds reduces their yield, so institutions buy other assets and yields fall generally, so long-term interest rates fall (maybe not true at ZLB where cost of holding cash is zero)
3) Confidence - people expect output to be higher next period, so will smooth consumption and consume more this period too
4) Increases market liquidity - encouraging trading, markets function more smoothly, interest premia on illiquid assets fall (less so in UK where gilts are reasonably liquid)
5) Money - increases liquid assets, banks have more reserves so can lend more (in theory)

Question 5

Why might QE not have worked - i.e. not satisfied money neutrality? [2]

Answer 5

1) If the new money created simply sits in a bank’s reserves, its velocity will be zero, and there will be no increase in the price level
2) The recession meant an increase in the output gap - QE lowered yields and thus interest rates, but the increased demand only increased output, not prices

Question 6

Define the Taylor rule mathematically

Answer 6

Nominal interest rate = natural real rate + inflation + inflation gap + output gap

i_r = rⁿ + π^t + α(π_t - π^T) + β(y_t - yⁿ)

α and β represent central bank preferences

Question 7

Why do we target inflation, not output? [3]

Answer 7

1) Inflation targeting captures the idea of the long run Phillips curve that there is no long run inflation/output tradeoff
2) Inflation disequilibrium is more costly than output disequilibrium
3) It is hard to specify an output target when we don’t really know what the natural level is

Question 8

What is inflation bias?

Answer 8

When efforts to increase output inadvertently increase inflation above target, without actually increasing output

Question 9

How does inflation bias occur? [4]

Answer 9

1) The government has an incentive to increase output closer to the natural rate and improve welfare
2) It cuts interest rates and the economy moves up along the PC - although inflation is higher, output is also higher, and the economy is on a better indifference curve
3) Next period, inflation expectations adapt, and the PC shifts to the left - output falls and inflation rises
4) This repeats each period until the economy is back in line with where it started - the same level of output but higher inflation. The gap between initial and final inflation is the inflation bias.

Question 10

Why does inflation bias occur?

Answer 10

Because policy makers are myopic - e.g. a politician wanting to win an election

Question 11

Why does inflation bias still occur if the policy maker is forward looking?

Answer 11

The economy will move straight from the low inflation point to the high inflation point without going through the changes in output.

Knowing that the government has an incentive to renege on its promise of meeting target inflation (because they could increase output), people do not believe the initial promise.

Question 12

Define time inconsistency

Answer 12

A decision-maker’s preferences change over time, in such a way that a preference, at one point in time, is inconsistent with a preference at another point in time - e.g. inflation bias with forward-looking expectations

Question 13

Explain the problem of time inconsistency with the example of taxation

Answer 13

At t=0, the government wants to encourage capital formation, so optimally promises not to tax capital

At t=1, the private sector invests in capital

At t=2, now that capital is installed, it is optimal for the government to tax capital

The forward-looking private sector will anticipate this and not invest at t=1 - by allowing the government to re-optimise, everyone is worse off. It is better to tie the government’s hands

Question 14

How might the problem of time inconsistency be solved?

Answer 14

1) Follow a time consistent policy
2) Follow a policy rule (e.g. the Taylor rule) - will be inferior to the time inconsistent optimal plan, but perhaps better than time consistent ones
3) Delegate policy to a central bank
4) Commitment mechanism - e.g. personal reputation
5) Estabilsh credibility that you will not re-optimise
* The MPC has economists from outside the BoE, publishes minutes and a voting record, and has a clear mandate*