MBA 34 Monetary policy Managerial Excellence 1

MBA 34 Monetary policy Managerial Excellence – 1° Term Class 19 The firm and its environment - Francesco Giavazzi Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 1

Motivating Questions • How to predict monetary policy ? – How low will the Fed push interest rates in 2009 ? – Will the ECB cut interest rates despite rising inflation? • What are the effects of monetary policy? – Will there be a US recession in 2008 ? – What will happen to the $ or the Pound in 2008 ? – How long will credit crunch continue ? Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 2

Outline 1. Some terminology 2. The effects of monetary policy 3. The role of monetary policy - Goals and strategies 4. Monetary policy in practice Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 3

1. Some terminology Operating instrument = almost always interest rates Intermediate targets = money supply, credit, exchange rate, inflation forecast Final objectives = inflation, output Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 4

The Monetary Policy Instrument in the Euro area The minimum bid rate for the main refinancing operations is the key ECB interest rate Weekly frequency auctions, two-weeks maturity The amount is assigned at the rate proposed by the bank in descending order (bids are listed from the highest to the lowest offered interest rate) Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 5

The monetary policy instrument in the US • Fed funds rate (overnight interbank rate) • The Fed chooses a target rate (Fed funds target) • Trading desk of NY Fed intervenes in the Fed funds market to keep mkt rate as close as possible to target Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 6

Market Rates Asset Prices How CB decisions affect the economy - The “monetary transmission mechanism” Demand Official Rate Output & Inflation Expectations /Confidence Copyright SDA Bocconi 2008 Supply Monetary Policy Lecture 1: theory 7

2. The effects of monetary policy Tighter monetary policy (MP) temporary and delayed fall in Y permanent and delayed fall in P i. e. MP is non-neutral in the short run - “Neutrality” of MP? As money supply changes, real GDP and other “real” variables stay unchanged - Source of non-neutrality? “Nominal rigidity”, namely: prices, or wages, or debt contracts, set in advance, hence fixed in nominal terms Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 8

Key points to remember • Expected MP is “neutral” • Unexpected MP is “non-neutral” • Why? “Expected” MP is embodied in contracts, “unexpected” is not • Nominal rigidities create a role for unexpected MP Underlying idea: Central Bank can act first, reacting to shocks, for it has “information advantage”. Workers and firms cannot or can do it more slowly Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 9

P The effects of EXPECTED expansionary monetary policies -- no GDP gains, only inflation E’ E AD’ AD GDP Copyright SDA Bocconi 2008 Permanent GDP Monetary Policy Lecture 1: theory 10

P The effects of UNEXPECTED expansionary monetary policies SRAS’ E’’ SRAS E’ E AD’ AD Permanent GDP Temporary GDP gains, no long-run gains Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 11

Why GDP gains are only there in the short run Monetary expansion (unexpected cut in policy rate) shifts AD to the right In the short run, GDP gains. Yet such gains don’t last forever. Let’s see why § AD increase also makes P go up § Over time P feeds into higher nominal wages § Why do wages go up? At next wage bargaining: wage claims due to today’s P. AS shifts to the left § As nominal wages change, short-run AS (entire curve) shifts to the left. It’s a cost of production increase § Short-run AS keeps shifting leftwards until GDP above its long-run average § Adjustment stops when GDP back to its long-run average Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 12

3. The role of monetary policy MP supposed to stabilize GDP, P shocks keep GDP= GDP*, π = π* (inflation close to target, may be 2%) • Two kinds of shocks – Aggregate demand (eg. House prices fall) – Short run aggregate supply (eg. oil or commodity prices) Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 13

Aggregate demand shocks – housing prices fall, AD shifts to the left Inflation Y=Y* Aggregate demand Try to stabilize demand shocks – Y no trade off between Y and P Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 14

Aggregate supply shocks – oil price rises, short-run aggregate supply to the left Inflation Y=Y* Aggregate demand Y Difficult choice – trade off between Y and P Optimal policy depends on their relative cost In practice: let P rise, but avoid “second round effects” (do not validate expectation that price rise will continue Monetary Policy Lecture 1: theory in the future) Copyright SDA Bocconi 2008 15

4. Monetary policy in practice Long-run price stability today recognized as overriding goal of monetary policy both by governments and central banks. Implementation controversies Ø Are there other objectives of monetary policy? If yes, which priorities? Ø Are monetary policy goals best achieved if CBs conform their behavior to a rule? Should this rule be explicit or implicit? Two sets of alternatives Ø hierarchical/dual mandate Ø implicit/explicit inflation objective mandate Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 16

Monetary policy rules around the world Many countries have adopted ‘inflation-targeting’ regimes, i. e. hierarchical & explicit mandates US Fed: dual & implicit mandate § Over time, goals interpreted by Greenspan. “Price stability means inflation so low and stable that it is ignored by households and businesses” § With Bernanke, gradual and hidden evolution towards inflation targeting. Fed announces inflation forecasts at 3 years – same as inflation targeting ECB § Not an explicit inflation-targeting regime, but price stability is primary objective (Art. 105, Maastricht Treaty) and Governing Council sets explicit (now 02%) inflation target Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 17

Inflation-targeting regimes Usually: hierarchical mandate Price stability = primary objective Ø goal: point-wise (often 2% per year) or within a range (often 1 -3%) Measure of inflation Ø comprehensive measures (e. g. CPI) vs. measures of ‘core’ or ‘underlying’ inflation Flexibility recovered through escape clauses Beyond explicit targets, program includes period over which deviations have to be eliminated (18 -24 mths) Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 18

The Taylor rule In practice most central bankers implement inflation targeting following unofficial rule of thumb in setting R. This is the Taylor Rule (from John Taylor, Stanford economist) Rt = r* + c ( - *) + d (output gap) R = target policy rate (e. g. discount rate) r* = long-run level of target rate in real terms * = long-term goals for inflation (2%? ) = actual inflation c, d = positive constants, measuring CB response to deviations of inflation and output from their long-run values (output gap=y-y*) Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 19

Implications from Taylor rule 1. As = * and y=y*, the nominal discount rate R should stay constant equal to its long-run level (= r * + *) 2. As economy overheats (eg positive AD shock), R should go up for > * and y>y*. The opposite if economy hit by negative AD shock 3. What should central bankers do with asset (foreign exchange, stock, bond, housing) markets? If CB follows Taylor rule, it should do nothing as such to counteract asset market bubbles or bubble bursting, UNLESS asset price behavior is threat to stability in inflation or GDP. In practice, a straight jacket. Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 20

Implications from Taylor rule A big problem when the economy is hit by negative supply shock (oil or commodity prices up or upward shift of wages) Rule doesn’t give unambiguous indication about what to do with R § > * R should go up § y<y* R should go down Net effect on R depends on values of c and d § Need estimate of “c” and “d” in the Taylor rule from past data on inflation, GDP, discount rates § Plausible values: c=1. 5, d=0. 5 § If c<1, Taylor rule would be de-stabilizing. Why? Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 21

Credibility and comunication are key in inflation targeting programs Eg. New Zealand • > * • Under inflation targeting, financial markets expect restrictive MP (and short term interest rate R to go up) • exchange rate appreciates • As exchange rate appreciates exports go down, imports more competitive. Aggregate demand down, with no need to raise short term R Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 22

Typical dilemmas in small open economies: how to react to exchange rate changes Eg. New Zealand vs Australia • Asian financial crisis late 1990 s • Exchange rate depreciates => rises • Australia: let rise without raising R => good outcome (Y stable, fell eventually) • New Zealand: fear of rise in e => raises R => deep recession Copyright SDA Bocconi 2008 Monetary Policy Lecture 1: theory 23