Monetary Economics Lecture 12. December 11, 2007

1. Monetary EconomicsLecture 12. December 11, 2007 Robert TCHAIDZE MONETARY ECONOMICS

2. Issues to Discuss • Monetary transmission channels (Mishkin 1995, Journal of Economic Perspectives Symposium) • Operational procedures • Monetary policymaking questions (Alan Blinder “16 questions and about 12 answers”) MONETARY ECONOMICS

3. Monetary Transmission • Changes in monetary policy variables (i.e. monetary aggregates and interest rates) affect economy through various channels. • Magnitude and order of importance of these channels are debated. • These channels are: • Interest rate channel • Exchange rate channel • Credit channel • Bank lending channel • Balance sheet channel • Asset price channel • Expectation channel MONETARY ECONOMICS

4. Interest Rate Channel • Mechanics: • Money supply decreases → • Interest rate increases → • Investment decreases and so does output • Initially was thought to be affecting firms. • Later it was recognized that this channel affects as well consumer spending, such as residential construction and consumption of durables. • John Taylor argues this channel has strong affects, while Bernanke and Gertler argue that empirical studies do not confirm this. MONETARY ECONOMICS

5. Exchange Rate Channel • Mechanics: • Money supply decreases → • (Interest rate increases →) • Exchange rate appreciates → • Net exports decrease and so does output • There is an agreement on importance of this channel. Movements in exchange rate affect economy in several ways: • Cost of imported goods, whether final consumption or production inputs; • Competitiveness of exports and import substitutes; • Balance sheets (in case of liability dollarization). MONETARY ECONOMICS

6. Asset Price Channel • Mechanics: • Money supply decreases → Expected prices, including stock, decrease → • Either because public has less money (monetarist view) or because interest rate increase reduces demand for equity (Keynesian) • Tobin’s q decreases → Investment decreases and so does output. • An alternative channel works through wealth effect impact on consumption. MONETARY ECONOMICS

7. Bank Lending Channel • Mechanics: • Money supply decreases → Deposits decrease → Bank loans decrease → Investment and consumption decrease and so does output • Puts emphasis on quantity not price. • Matters for small firms as big firms can raise funds directly via equity issuance. • It has been argued that given innovations in financial markets, this channel is likely not to be too important. But it may remain so in countries with underdeveloped financial markets. MONETARY ECONOMICS

8. Balance Sheet Channel • Emphasizes the changes in net worth, which impact borrowing constraints. • Money supply decreases → Expected prices and net worth decrease → Adverse selection and moral hazard problems intensify → Lending decreases → Investment decreases and so does output. • Another impact is via cash flow. • Money supply decreases → As interest rates rise, cash flows decrease → Adverse selection and moral hazard problems intensify → … • Likely to affect consumers as well. MONETARY ECONOMICS

9. Operational Procedures • Three instruments: • Open market operations; • Setting required reserves ratios; • Lending via Discount window. • Mostly used is the first with an aim of affecting overnight interest rate at the interbank market. • Open market operations happen usually in REPO market. MONETARY ECONOMICS

10. Financial System • The system comprises of commercial (deposit money) banks, mortgage credit institutions and other financial institutions, such as pension funds, mutual funds, insurance companies, etc. • Banks need liquidity for conducting transactions on behalf of their clients, conducting transactions with each other, or for their own activities. • Central Bank needs to evaluate amount of liquidity demanded and amount of existing liquidity and if necessary conduct open market operations. MONETARY ECONOMICS

11. Role of a Central Bank • Source of liquidity (money) via open market operations or as a lender of last resort; • Banker of banks, which keep reserves in the central bank, used for settling transactions with each other, the CB, and the government; • Clearing house for banks, which conduct transactions with each other; • Agent of the fiscal authorities; • Maintenance of foreign exchange reserves. MONETARY ECONOMICS

12. Policymaking. Blinder’s Questions Institutional Design • What is the proper objective function for monetary policy? • How transparent should the central bank be? • Should the central bank be an inflation targeter, as that term is commonly used nowadays? • Should monetary policy decisions be made by a single individual or by a committee – and, if the latter, what type of committee? • Should the central bank also regulate and/or supervise banks? MONETARY ECONOMICS

13. 1. Objective Function • In academic papers mostly common is the loss function (π – π*)2 + λ (y – y*)2 • What should λ be? • How to estimate y*? • y* = AF(L*(1 – u*), K) • Mechanic trends MONETARY ECONOMICS

14. 1. Objective Function • What should number π* be? • Most of CBs target 2%. Not lower because indices are biased upwards; to avoid deflation and liquidity traps • What measure of inflation to use? • PPI/CPI, wages/prices, include or not asset prices? • Core or headline, i.e. exclude or include energy and food prices? • Most of CBs choose headline inflation • Monetary policy is unlikely to have much of an impact over energy and food MONETARY ECONOMICS

15. 2. Transparency • Paraphrasing Einstein: Every Central Bank should be as transparent as possible, but not more so. • Expectations and democratic accountability. • Forecasts based on … • … unchanged monetary policy? • … path expected by the markets? • … CB’s own (conditional) forecast? MONETARY ECONOMICS

16. Other Institutional Questions • Inflation targeting • Widespread and gaining popularity but … • Committee or single individual • Pooling of information; Diversity of backgrounds, methods, and approaches; Checks and balances. • Supervision • Separate or not? MONETARY ECONOMICS

17. Policymaking. Blinder’s Questions Operating Principles • Is the observed proclivity of central bankers to avoid policy reversals justifiable? • Does the revealed preference of central bankers for gradualism make sense? • Is “fine tuning” possible after all? And if so, should central bankers attempt to fine-tune their economies? • Should central banks lead or follow the financial markets? • Should central banks in floating exchange rate regimes intervene in the foreign-exchange market? • Should central banks use derivatives in the conduct of monetary policy? MONETARY ECONOMICS

18. Policymaking. Blinder’s Questions Transmission Mechanism • Transmission through the term structure of interest rates • Transmission through the exchange rate • How should the central bank deal with asset-market bubbles? • How should the central bank deal with the zero lower bound on nominal interest rates? • Do the world’s giant central banks have global responsibilities? MONETARY ECONOMICS