Monetary Policy Flashcards
What is the Taylor Rule?
It is essentially a forecasting model used to determine what interest rates will be, or should be, as shifts in the economy occur
What are the issues of the Taylor Rule?
- LR equilibrium real rate of interest is unobservable
- Idea and measurement of growth of output is problematic
- Hard to measure the output gap (FOMC members have different judgements)
- No account is taken of the exchange rate
How do deliberations of the BoE’s monetary policy committee fit in with the Taylor Rule?
BoE doesn’t take the omission of the exchange rate, terms of trade, or foreign interest rates into consideration. This accounts for the failure of the Taylor Rule to describe the BoE’s interest rate setting
What has ‘forward guidance’ added to inflation-targeting as practised by the BoE?
‘Forward guidance’ is when the CB announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.
It influences long-term interest rates (through short-term rates) and market expectations, both of which influence inflation
Why was ‘forward guidance’ believed to be necessary?
Might influence inflation expectations, for example, higher inflation expectations can help boost spending and economic growth.
Also influences long-term interest rates through short-term rates
Why could nominal income appear to be an attractive target for monetary policy in current circumstances?
Tempting during severe recessions as it will steer nominal income back to the desired level.
Preferable if the economy is hit by a supply shock, in which output falls as prices rise.
Target amount of nominal spending that takes place in the economy (rate of change of nominal income)
Avoid the chaos that unstable monetary environments can create.
Why did the BoE reject a nominal income target?
CBs prefer inflation-targeting as it gives discretion in how CBs respond to differing shocks.
NI is great to deal with demand shocks, but not for supply shocks
How should the CB’s loss function be reformulated to incorporate the inclusion of macro prudential regulation into the independent bank’s remit?
‘mu’ = private sector leverage (debt/nominal income)
Total private sector debt relative to nominal income
What potential conflicts are there as a consequence of the reformulation of the CB’s loss function?
How do you determine ‘mu*’?
What is the best way to reduce ‘mu’ given that it is difficult to reduce outstanding debt? Reduce nominal income, done by raising inflation. Does this compromise the inflation target?
CB obtains a higher loss
Does macro prudential regulation imply a stronger case for CB independence?
Domestic banks gain from the debt created (=profit), therefore they will want to lean on the CB to get as light a regulation as possible. That is why now, with macro prudential regulation, the case for CB independence may be a great deal stronger.
Or is it a question of gov independence, or independence of the finance industry?
What are the arguments for CB independence?
Solves time inconsistency and inflation bias problem
- Can you lower inflation without a rise in unemployment? CB independence makes low inflation credible, therefore reduction in inflation should not deviate employment from the equi natural rate of employment (use graph) –> no rise of unemployment.
- A credible, low inflation policy needs to make reneging either costly or infeasible (solve inflation bias)–> CB independence=solution to inflation bias
Expansion of CB’s remit to include macro prudential regulation needs CB independence
Transparency in policymaking
- reduce output lost during disinflation (markets have solid expectations)
- reduces errors and instability
- transparency holds the CB accountable, which enhances credibility
How independent is a CB?
Political independence
-how much influence does the gov have over the CB?
-how involved is the gov in appointing/dismissing CB head?
-how often do the CB and gov meet? CB needs to know a lot about FP
Economic independence
-how freely can CB set MP?
-does it finance the gov’s deficit? If it does tend to observe much higher inflation as the CB needs to print money to finance gov spending
Evidence of CB independence
Test if you get lower inflation with CB independence.
Alesina and Summers: CB independence lowers inflation to no cost to employment or growth.
But is the relationship causal? Inflation could have been lowered and then the CB became independent. Or, the CB prevents inflation from rising, didn’t necessarily lower it.
Describe a fixed exchange rate for monetary policy
Target a fixed nominal exchange rate against a country with stable prices (anchor), because goal is to achieve price stability.
Constant nominal exchange rate implies no autonomous MP as interest rate = anchor interest rate.
Works if:
-The CB of the anchor country maintains a low inflation rate
-Both countries business cycles are well-synchronised
- Low inflation differentials (must start with the same inflation rates) and risk premiums (higher risk=higher interest rates)
Would you expect an inflation-targeting CB to operate a fixed exchange rate?
No because domestic inflation=foreign inflation, which means domestic inflation is dependent on the anchor country’s inflation
(look at seminar 2 question 1 equations)
