Chapter 9 Monetary Policy Framework
Introductions. Introduces 7 steps that are followed in the formulation of a countries monetray policy framework.
(1) The Ultimate objective of monetary policy
(4) Price stability is usually achieved at the cost of inflations. Higher inflations rates in the long rung achieve nothing hence Monetary Policy is unable to influence real variables in the long rung. However this is not true for the short run
(3) Monetary policy instruments
(2) Broad Philosophy used to achieve targets/goals
(1)Market orientated measures
(2) Direct controls
(4)Monetary Policy Regimes
Indicators and instruments rules
Financial-conditions index
The monetary conditions index
The Taylor Rule
The McCallum Rule
Forecasting targeting
Monetary Operational Procedures
Cash reserve requirements
Open Markets transactions
Quantitative Easing
Transfers of official deposits between CB and other Banks
The discount window
Moral Suasion
Direct controls
Institutional Arrangements
Independence
Accountability
Transparency
(1) Monetary policy has the main objective of maximizing social welfare
This is often hard as there are various social difference and becomes more of a balancing act
(2) Henri Theils Social Welfare functions was used to analyze and estimate a social optimum
Z = b(u-u) + (I-I)
Social Optimum was achieved at the intersection of the Social welfare function and the Expectations-Augmentsed Phillips curve, also intersecting the long run vertical phillips curve. Still did not explains what the ulimated objective of monetary policy was
(3) A good guide to answering the above questions is to look at what monetary policy is able to achieve.
Price stability since the 1980s has generally been accepted as the long run goal of monetary policy as it contributed to social equity and monetary policy has the power to influence it.
When an economy is effected by an external shock this has effect on inflation. the decision by authorities on how to react to this is important as it will determine the level of output in the transition period before price stability is acheive again. This is where MP is useful in stabliizing the economy.
DUAL TRAGET: Price Stability & Fine tune growth in GDP iis difficult to achieve because
(5) VOLCKER
It is difficult to distinguish between the short and long run
Superior technical skill is required
May Have a negative effect on the credibility of the monetary authorities
Price stability is the situation in which expectations of generally rising prices over a considerable period are not a pervasive influence on economic and financial behaviour
(6) GREENSPAN
Price levels sufficently stable so that expectations of change to do not become a major factor in key economic decisions
(1.1) Monetary operational procedures that affext interest rates via the price mechanism in the market, this method has generally been appliced by monetary authorities in most countries
(2.1) Direct controls by monetary authorities on banks and financial institutions regarding money creations, credit extension and interest rates
Until 1980
From 1980
(2.2) DISADVANTAGES
Ineffective as direct controls can be (1) circumvented by the institutions on which they apply
(1.2) ADVANTAGES
(1) More equitable as the are not only directed by the actives of the financial and banking sectors
Cause (2) inefficiencies in the allocation of production factors. Where direct controls are apllied banks could favour certain customers. Deviation from competitive circumstances
(3) Inefficient institutions can stay in business bt undertaking transactions that efficient institutions cannot as a result of the controls
(2) Less costly and easier to apply
(1.3) DISADVANTAGES
(1) The demand for credit can behave in a very unorthodox way. Curtailing credit extension could increase interest rates which could result in distress borrowing
(2) Penalise certain sectors in the economy more heavily than others
(3) Political pressure can lead to the ineffective conduct of monetary policy.
(1.4) Despite its disadvantages Market orientated measures are regarded as the most effective way of establishing and maintainging price stability.
(3.1) Authorities need to make a choice about what monetary instrument or operational variable should be utilised to Achieve the ultimate objective
(3.2) Monetary instruments
(2) Control of monetary base
(3) Control of interest rates
(1) Control of credit extension
Falls away if an economy have opited for a market orientated ,measure
(3.3) In most countries the choice of instrument has been narrowed down to short term interest rates are the monetary base is difficult to control
(3.4) William Pole (1970) argued that the choice between interest rate or a money supply instrument will depend on whether the external shock occurs in the money or goods market
(1) Money demand shock affecting money market, interest rate instruments are prefered.
(2) Goods market shock money supply instrument is prefered to cause smaller fluctuations.
See page 182-183 for diagram
(4.1) Generally determined by the central banks act. Regimes can be distinguished by the NOMINAL ACHOR that is used to achieve the ultimate objects.
Nominal Achor can either be
(4.2) Intermediate target
(4.3) Final target
1) An aggregate that occupies and intermediate position between the operational variable and the ultimate objective on monetray policy
3) Operational variable is adjusted to achieve these variables
4) Proponents of this theory believe that it enables the monetary authority to adjust the operational variable quickly
(1) Operational Variable set directly at achieving the ultimate objective
Changes are based on available information and according to its proponents the use of an intermediate variable does not necessarily speed up policy response
2) When used as the nominal anchor it must meet 2 requirements
1. Close relationship between intermediate target and ultimate target
2.Intermediate target must be susceptible to control by the operating target
5) Used for regimes that consist of exchange rates and monetary aggerates
Exchange rate targeting
Monetary Targeting
2) Used for regimes that target the inflation rate and the growth in nominal GDP
Inflation Targeting
Nominal Income targeting
(4.5) Regimes
.
1.1) Those with NO independen currency
2) Have established a currency board
This is where domestic currency is issued only against foreign exchange fully backed by foreign assets. currency board in some cases becomes the central bank with very limited functions holding no notes or bills issued by the government and is not the lender of last resort for domestic banks. Limits room for discretionary monetary policy
3) Allow another country's currency to serve as their legal tender, "Dollarisation"
Proponents believe that dollarization enables small countries to achieve price stability. the adoption of this regime means the country surrenders it monetary authorities ability to control the monetary policy of the nation.
1.2) Those using exchange rate peg as their nominal anchor
1) Have arrangements with no seperate legal tender leads to the formation of a Monetary union e.g. Euro
3 Main Routes
1) Fixed peg arrangement
2) Crawling peg
3) Managed float
Pegs currency at a fixed rate to another country or basket of countries. Basket can be standardised where the currency is pegged to the value of special drawing rights (SDR). Monetary authority maintains fixed parity through sale and purchase of foreign exchange in the market
Adjusted periodically in small amounts at a fixed rate in response to quantitative indicators e.g.inflation.Crawling peg can be set backward or forward looking.
Exchange rates maintained in bands which can either be horizontal or crawling.
1) Horizontal bands- currency maintains within fixed margin. limited degree on monetary policy discretion depending on the width of the band.
2) In a crawling band the currency is allowed to fluctuate within a horizontal band with the margin being adjusted periodically in response to select economic indicators.
ADVANTAGES
1.) Inflation rate convergence. Rate Inflation in domestic currency will converge with the anchor currency or most heavily weighted currency in the basket.
2) Easy to understand and transparent.
DISADVANTAGES
1) Loss of monetary control. Domestic interest rates will become closely linked to those of the anchor country.
2) Domestic economy gets affected by shocks in anchor country due to interest rate convergence
3) Can lead to speculative attacks on currency
4) Weakens the accountability of policy-makers particularly in emerging markets.
2) Monetary Targeting
Based on the monetarist idea that money supply must be increased steadily to accommodate growth in Real GDP while keeping inflation low.
Widely applied after the breakdown of the brettonwood system until the mid 1980's
The view is that the economic process is inherently stable and money role is to prevent any instability
Monetary targets are derived from the Quantity Theory of Money. MV = PY
The Growth Target from money was calculated as
m = (pie) + Y - V Trend
According to this approach the operational variable must be changed mechanistically in line with
It - It-1= Y(mt - M*) with Y >0
From the formula. If money supple growth fall short of the targeted growth, short term interest rates must be reduced and vice versa
ADVANTAGES
1) Central bank is able to adjust monetary policy in accordance with domestic circumstances.
2) Improves credibility of central banks because of the clear-cut rule in this approach.
DISADVANTAGES
1) Difficult to control the money supply
2)** Income velocity is unstable **hence the relationship between the monetary target and the ultimate objective becomes weak.
3) Nominal Income targeting
Target for the growth rate in nominal GDP
When applied Price stability is the long run goal and a stable income is the short term goal.
(pie) + Y + M + V different to monetary targeting as V is calculated differently
Actual forecasted value of velocity is used in the nominal income target.
3 different forms
1) Growth rate targeting - sum of the rate if income in the inflation target plus the growth rate of potential real GDP
2) Level targeting - base year value grows each year with the sum of the rate in the inflation target and growth rate of potential real GDP
3) Hybrid Nominal Income targeting - growth rate in nominal income is adjusted with output divergences in the preceding year but where deviations in the in the targeted inflation rate the the preceding year are not taken into account when calculating the target value.
DISADVANTAGES
1) Monetary policy held responsible for mistakes in other economic decision-making when growth in potential GDP is not achieved. Leads to less clear cut policy assignment by the central banks
2) Forces authorities to announce their views about the potential growth rate
3) Long delay before national income data become available.
4) Neutralizes the big effect inflation targeting has on expected inflation rates
4) Inflation Targeting
A framework for monetary policy characterized by the public announcement of official quantitative targets over a particular time horizon which the view that low inflation is the primary long term goal.
Rule base version page 190
Countries Using this regime divided into 3 groups
1) Fully fledged inflation targeting
2) Informal inflation targeting
3) Inflation targeting lite.
Characteristics
1) Most important is the official announcement of a target numerical value
2) Central bank is allowed considerable flexibility in achieving an maintaining the target.
3) It is an information inclusive strategy with a reduced role for intermediate targets
4) Finally characterized by increased transparency and accountability.
ADVANTAGES
1) Effects public's inflation expectations which help to reduce inflation and maintain price stability.
2) Highly transparent and can be easily understood by the public.
3) Disciplines monetary policy implementation and increases central bank's credibility,
DISADVANTAGES*
1) Too rigid because it focuses on the inflation target which could lead to low economic growth
2) Inflation cannot be easily controlled by monetary authorities
The inflation target is normally defined as the rate of increase in an index reflecting the cost of living.
Aid Monetary authority in achieving its ultimate objective
is barometer of the degree of monetary tightness. Used to determine MP stance Reflects changes in short term interest rates and exchange rates.
MCI = (a x chnageE) + (a x ChangeI)
Disadvantages
No info in ST interest rates.
exchange rate is not an indication of monetary policy
Difficult to estimate the index
C
Exchange rate and monetary targeting rely heavily on intermediate targets. These targets serve as a leading indicator to fix the operational variable as it has a close relationship with the ultimate target
Nominal Income and Inflation targeting regimes dont reply on intermediate targets hence a broad judgements about current and expected economic conditions that could effect their ultimae goal needs to be done