Monetary Policy and Inflation

Question 1

Role of central banks

Answer 1

• banks need money in order to provide loans and services
• banks borrow from each other: interbank market
• central banks lend whatever is demanded by banks at the interest rate it chooses (policy rate)
• this affects the commercial banks lending rate to firms and households (policy rate + markup)
• accepts deposits from banks at the interest rate

Question 2

Monetary Policy channels

Answer 2

• central banks set the policy interest rate to affect inflation and real interest rates
  1. given the target inflation, estimate a target for the total aggregate demand, Y, based on the labour market equilibrium and Phillips curve
  2. Estimate the real interest rate, r, producing this level of aggregate demand based on the multiplier model
  3. Calculate the nominal policy rate, i, that will produce the appropriate market interest rate

Question 3

Lower interest rates

Answer 3

• lower cost of borrowing to pay for a house (mortgage)
• more people able to afford to buy a house
• prices will tend to be higher (if supply unchanged)
• leads to inflation

Question 4

Interest rates affect asset prices

Answer 4

£1 today is worth £1 x (1+i) in one year

£1 in one year is worth £1/(1+i) today (present value)

• lower interest rates increase the PV of money received in he future
• leads to prices of assets rising
• households who own assets feel wealthier
• they will spend more
• aggregate demand increases
• leads to inflation

Question 5

Expectation and confidence from central banks

Answer 5

• consistent policymaking & good communication with public builds confidence in the central bank
• this can lead firms to expect higher demand and therefore increase investment
• households may be confident that they won’t lose their jobs and increase their consumption

Question 6

Fisher equation with expectations

Answer 6

real interest rate = nominal interest rate - expected inflation rate

the exchange rate is no. of units of home currency for one unit of foreign currency, which is important for small open economies

Question 7

Exchange rate when central bank lowers interest rate

Answer 7

• the return to the countries bond declines
• decline in demand from international investors
• demand for the currency to buy those bonds declines
• Depreciation: decline in the currency price in terms of other currencies
• goods sold abroad are now cheaper, and imported goods are more expensive
• higher export demand for domestic products (X), lower demand for imported goods (M)
• raise in aggregate demand

Question 8

Monetary Policy and the Multiplier

Answer 8

• Following a recession, aggregate demand falls and so does output and there’s less consumption
• a lower interest rate stimulates investments due to changes in expectations and asset prices
• autonomous consumption, Co, could also increase

Question 9

Monetary Policy in a boom

Answer 9

• a boom will shift the aggregate demand line upwards, so the central bank must raise the interest rate to dampen demand and return the AD line back to starting point

Question 10

why would central bank want to curtail a boom?

Answer 10

from the Phillips curve we know that a boom leads to higher inflation, and if expectations adjust to past inflation to rising inflation it’ll lead to a wage-price spiral

Question 11

is it that easy for these adjustments?

Answer 11

• timing is everything

it’s difficult to decide whether a downturn is temporary or outlines a longterm weakness

• difficult to judge whether an increase in inflation is temporary, if a boom is a bubble or motivated by fundamentals
• difficult to predict whether and how Phillips curve will move
• Gov could play a role in a recession by cutting taxes, or by boosting spending

but fiscal policy is complicated to adjust and inflexible

Question 12

Zero lower bound - limitation of monetary policy

Answer 12

• short term nominal interest rate cannot go below zero
• if the policy interest rate were negative, people would have to pay the bank for holding their money (just would hold as cash)
• when the economy is in a slump, a nominal interest rate of zero may not be low enough to stabilise the economy

Question 13

Quantitative easing

Answer 13

an alternative strategy in a recession

• central bank buys bonds and other financial assets
• this raises demand for bonds and other financial assets, thus increasing prices
• this boosts spending
• particularly on housing and other consumer durables because both the cost of borrowing and return to holding financial assets has gone down

Question 14

Negative interest rates

Answer 14

• banks more willing to charge negative interest rates on firms than on individuals
• in cashless societies, more expensive to store cash, so negative interest rates more effective

Question 15

Monetary Union - limitation of monetary policy

Answer 15

• the policy may not be available to a country
• members of the eurozone gave up their own monetary policy when they joined the currency union
• Main issue is that the interest rate set by the European Central bank may be more appropriate for some countries than others
• after the financial crisis, unemployment was low and falling in Germany but in countries such as Spain and Greece it was high and rising

thus there’s high economic costs

Question 16

2001 recession

Answer 16

the cause was the end of the tech boom in the late 1990s

firms had been overoptimistic about the profits to be made on investment in new technology and have overestimated ICT

led to a decline in non-residential investments

the slowdown led to rising unemployment and falling inflation, as expected from a negative demand shock

Question 17

Monetary policy in the recession

Answer 17

• drop in nominal interest rates helped boost residential investment
• also helped non-residential investment to recover

Question 18

Fiscal policy in the recession

Answer 18

• tax cuts and increased spending (through multiplier model)
• GDP and inflation recovered quickly
• unemployment remained high

the end of the tech bubble pushed aggregate demand down but monetary and fiscal policy shifted it back up

Question 19

Great moderation

Answer 19

a period of widespread steady growth, low inflation, and low unemployment between the 1980s and 2008 financial crisis

Question 20

factors of great moderation

Answer 20

• independent central banks to increase credibility
• inflation targeting: central bank changes interest rates to influence aggregate demand in order to keep economy close to an inflation target

Question 21

Central bank independence

Answer 21

govs hand over the task to independent institutions rather than controlling inflation themselves

• because unexpected inflation redistributes wealth from creditors to borrowers
• govs are the largest borrowers
• we need an institution with more credibility (with less incentive to generate inflation)

evidence suggests that independence does help to reduce inflation

• commitment of central banks to an inflation target helps explain why the 3rd oil shock in the 2000s didn’t provoke high inflation
• even if the inflation rate rose temporarily no one expected it to last because the central bank was committed to preventing it

Question 22

Inflation targeting

Answer 22

the labour market equilibrium and thus the inflation-stabilising rate of unemployment will be different in countries (UK=5.9%, Germany=7.7% (2000s))

why control inflation and not unemployment or other factors?

• unemployment depends on structural features of the labour market, some of which are hard/take a while to change
• in general, real variables are slower to react than nominal variables
• bringing down inflation rapidly can increase unemployment just as fast
• a central bank that is given a dual mandate can be less inclined to act (so less credible)

Question 23

Capacity constraints and inflation

Answer 23

when capacity utilisation rises, usually firms increase investment to expand their ability to meet orders

however, building new plants and installing new equipment takes time

• firms have more orders than they can fill (capacity constrained)
• firms lose nothing by raising prices. Firms with similar products are capacity constrained too
• all firms face competition, demand curves are now steeper
• firms respond to higher capacity utilisation by raising the markup
• leads to a wage-price spiral