Monetary Policy: Central Bank Independence and Inflation Targeting

Question 1

Objectives of the ECB

Answer 1

“The primary objective of the ECB is the maintenance of price stability”

Question 2

ECB political independence statement

Answer 2

“The ECB (…) shall not seek nor take instructions from Community institutions or bodies, from any Government of a Member State or from any other body”.

Question 3

What is the Barro-Gordon Model?

Answer 3

The ability of government to manipulate output would lead to an inflationary bias.
Gov able to force U below the natural rate. LR worse off.

Question 4

What are the key implications of NAIRU and time inconsistency.

Answer 4

NAIRU: LR lower inflation can be achieved without increasing unemployment/lower output.

Time inconsistency: politicians would be unable to credible deliver lower inflation.

Question 5

Trends of inflation and CB independence (1950s to 1980s)

Answer 5

Negative relationship, greater the independence the lower the inflation.
Spain (inflation: 8.5%, CBI: 1.5)
Germany (inflation: 3%, CBI: 4)

Question 6

Trends of inflation and CB independence (1950s to 1980s)

Answer 6

Negative relationship, greater the independence the lower the inflation.
Spain (inflation: 8.5%, CBI: 1.5)
Germany (inflation: 3%, CBI: 4)

Question 7

Trends of inflation and CB independence (2000 to 2008)

Answer 7

Little correlation between the two variables.

Question 8

Anastasiou (2009)

Central Bank Independence

Answer 8

• Independence associated with lower inflation. No

significant relationship between growth or unemployment.

Question 9

Outline the new possible problem.

Answer 9

A temporary increase in unemployment.
ECB interprets as increase in NAIRU and increase its target unemployment rate.
ECB will not attempt stabilization after shift to the right.
ECB behaves as super-conservative
by attaching a zero weight to
unemployment stabilization.

Question 10

ECB (2003)

Answer 10

“the outlook for the euro area economy could
be significantly improved if governments
strengthen their efforts to implement structural
reforms in labour and product markets.”

Question 11

Khan and Senhadji (2001)

Answer 11

Inflation rates
above a threshold around 3 % have a negative
impact on growth

Question 12

Akerlof et al (1996)

Answer 12

Estimated that
lowering inflation in the US from 3 to 0 % would
lead to persistent higher unemployment and lower
output.

Question 13

Keynes: deflation

Answer 13

‘pushing on a piece of string’
Expected falling prices make
postponing consumption rational; ‘debt deflation’ – raises burden on borrowers → increased bankruptcy risk.

Question 14

Bernanke: inflation and CBI

Answer 14

‘Careful empirical studies support the view that more independent central banks tend to deliver better inflation outcomes than less-independent central banks, without compromising economic growth.’

Question 15

What is inflation targeting?

Answer 15

A target for inflation is set.
Monetary policy (mainly interest rates) set to achieve this implemented by ICB.
IT credibly delivers low and stable inflation, anchors expectations of low inflation even with shocks.

Question 16

Bernanke (2003)

Answer 16

“this discretion of
policy makers is constrained by a strong commitment to keeping inflation low
and stable.”

Question 17

Andersen et al. (2015)

Answer 17

Economic activity is stable around NAIRU.

No LR trade off between unemployment and inflation.

Instabilities in the money supply make IT superior to money supply targeting.

Fixed exchange rate regimes vulnerable to speculative attack.

Little or no role for active fiscal policy.

Question 18

Velocity of Circulation Trends (USA)

Answer 18

Stable increase to peak in mid 1990s and then steep fall, made steeper following the GFC in 2008.

Question 19

Mishkin (1997)

Answer 19

CB minimizing some loss function. Allows for lagged adjustment from sticky pries and forward looking behavior.

Delivers lower inflation without lower output growth or
higher unemployment in the medium run.

Evaluation: Ball and
Sheridan (2004)

Question 20

Trends of headline and core inflation in the Euro Area

Answer 20

Core HICP follows stable trend ranging from 0.5 to 2%.

All-items HICP range alot more from 4% to -0.75%, deflation following GFC.

Question 21

US inflation trades trend (Bureau of Economic Analysis for inflation, Bureau of Labor Statistics for the unemployment rate)

Answer 21

From the end of 2014 onwards there has been a steady increase in the inflation rate of both the core and overall index.

From 2014 onwards a steady decrease in the unemployment rate from 6.5% to 3.5%.

Question 22

Andersen et al (2015)

Post Crisis testing

Answer 22

Grwth = IT dummy varible, GAP (output gap), PY (potential growth in previous decade), DEBT (public debt to GDp ratio), PR (housing price to rent ratio, time dummy and error term.

Results indite higher growth in IT regimes.

Question 23

Evaluation of Anderson et al (2015) Post Crisis Testing

Answer 23

Output gap: varied widely, element of judgement involved.

Showed limited responsiveness of investment and consumption to interest rates.

Frankel (2012) Real supply side shocks and terms of trade shocks lead
to arguably inappropriate policy response. raising
interest rates before 2008 financial crisis.

Question 24

HM Treasury (2019)

Answer 24

Found large range of estimates of UK output gap ranging from -1% to 1% in 2019.

Question 25

Haver. IIF (output gaps)

Answer 25

For Greece large range in IMF, EC, OECD and IIF output gaps in % of potential GDP in 2019 from -5% to -20%

Question 26

Frankel: Death of Inflation Tareting

Answer 26

“evidently passed away in September 2009”

“its usefulness as a
figurehead for central banks, and fears that
there might be no good candidates to assume
its position as preferred anchor for monetary
policy.”

Question 27

Macrobond: CB policy interest rates

Answer 27

After GFC UK, Eurozone and US interest rates all drop to near 0%.

Question 28

Haver Analytics: interest rates below 0

Answer 28

In 2015: Sweden, Denmark and Switzerland below 0% interest rates.

Question 29

Outline the Zero Lower Bound (ZLB) problems

Answer 29

Aftermath of 2008 financial crisis zero lower
bound may prevent stabilising interest rate being
reached; this may perpetuate slowdown through a
deflation trap.

Question 30

Outline the events that occurred during the Crisis (inflation)

Answer 30

Large spread persisted due to increasing funding costs, reflecting increasing liquidity risk and credit risk which decreased risk tolerance.

Breakdown of mechanism of Monetary Policy, changing r will alter the lending rate.

Question 31

Outline QE: unconventional monetary policy

Answer 31

Quantitative Easing
Central bank purchases bonds from private sector, increases bond price, decreases interest rate and increases money supply.

Designed to restore proportion functioning of financial markets and provide further monetary policy accommodation

Question 32

Data on amount spent on QE.

Answer 32

FED: assets grown to $3.5 trillion.
Bank of England 25% of GDP.
ECB and Bank of Japan around 50% of GDP.

Question 33

What information frictions need to be true for QE to work.

Answer 33

QE signals lower future interest rates (signalling channel).

QE lowers uncertainty (uncertainty channel).

QE lowers exchange rate (exchange rate channel).

Question 34

What information frictions need to be true for QE to work.

Answer 34

QE signals lower future interest rates (signalling channel).

QE lowers uncertainty (uncertainty channel).

QE lowers exchange rate (exchange rate channel).

Question 35

What financial frictions need to be true for QE to work.

Answer 35

QE lowers liquidity premium (liquidity channel).

Causes a portfolio switch to higher risk assets (portfolio balance channel).

Encourages new borrowing/lending (lending channel).

Question 36

Balls and

Stansbury (2017)

Answer 36

GFC

Possible role for fiscal policy under such conditions.