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The New Face of Central Bank Policies and Its Reflections on Developing Countries Dr. Aylin Abuk Duygulu Dokuz Eylul University, Department of Economics.

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Presentation on theme: "The New Face of Central Bank Policies and Its Reflections on Developing Countries Dr. Aylin Abuk Duygulu Dokuz Eylul University, Department of Economics."— Presentation transcript:

1 The New Face of Central Bank Policies and Its Reflections on Developing Countries Dr. Aylin Abuk Duygulu Dokuz Eylul University, Department of Economics aylin.duygulu@deu.edu.tr

2 2 Old-Fashion Central Banking Central Banks (CBs) consider developmental issues. Central Banks (CBs) consider developmental issues. Monetary policy has a critical role to play in growth (Epstein and Yeldan, 2006). Monetary policy has a critical role to play in growth (Epstein and Yeldan, 2006). CBs have some monetary policy tools which are direct instruments to affect the economic sectors of high priority. CBs have some monetary policy tools which are direct instruments to affect the economic sectors of high priority. Direct instruments: such as credit allocation techniques (subsidized interest rates, credit ceilings) and capital controls. Direct instruments: such as credit allocation techniques (subsidized interest rates, credit ceilings) and capital controls.

3 3 CBs have more than one goals (employment, growth, price stabilization) so need more instruments (Jan Tinbergen: you need to have as many instruments as targets) CBs have more than one goals (employment, growth, price stabilization) so need more instruments (Jan Tinbergen: you need to have as many instruments as targets) Virtually CBs are Virtually CBs are -financing governments( so they are not independent), -financing governments( so they are not independent), - managing exchange rates, - managing exchange rates, - supporting economic sectors (Epstein, 2006). - supporting economic sectors (Epstein, 2006).

4 4 Most historians identify the following functions as being historically essential to the operations of CBs (Epstein,2006): Most historians identify the following functions as being historically essential to the operations of CBs (Epstein,2006): Unifying and issuing the countrys bank notes, Unifying and issuing the countrys bank notes, Acting as the governments bank, Acting as the governments bank, Acting as the commercial banks bank, Acting as the commercial banks bank, Serving as a lender of last resort to the banking and even the financial system as a whole, Serving as a lender of last resort to the banking and even the financial system as a whole, Conducting monetary policy to manage the foreign exchanges and the price level, Conducting monetary policy to manage the foreign exchanges and the price level, Conducting monetary policy to manage the overall level of economic activity, Conducting monetary policy to manage the overall level of economic activity, Allocating credit to promote national goals. Allocating credit to promote national goals.

5 5 In addition to these, there are at least three other roles of CBs: In addition to these, there are at least three other roles of CBs: -The Distributive role (the effects of CB policies on different class and groups) -The Political role (whether or not the CB is independent from the government) -The Allocative role (the effects of CB policies on the profitability and accessibility to credits)

6 6 Modern Central Banking In modern central banking, CBs attempt to (Epstein,2005): In modern central banking, CBs attempt to (Epstein,2005): - keep inflation at a very low level, - reduce central bank support for government fiscal deficits, -help manage the countrys integration into world trade and financial markets, -reduce the influence of democratic, social and political forces on CB policy.

7 7 We can name these attempts as neo-liberal approach to central banking (Epstein, 2006). We can name these attempts as neo-liberal approach to central banking (Epstein, 2006). This neo-liberal approach has following key features: This neo-liberal approach has following key features: - CB independence, - a focus on inflation targeting, - the use of indirect instruments of monetary policy.

8 8 Why modern central banking can be named as a neo-liberal approach? The main points of neo-liberalism include (Martinez and Garcia,2000): The main points of neo-liberalism include (Martinez and Garcia,2000): - The Rule of the market - Cutting public expenditure for social services - Deregulation - Privatization - Eliminating the concept of the public good or community and replacing it with individual responsibility.

9 9 Key features of neo-liberal approach to central banking

10 10 CB Independence Monetary policy conducted by independent CBs played an important role in reducing inflation rates. Monetary policy conducted by independent CBs played an important role in reducing inflation rates. What is CB independence? What is CB independence? CB independence implies first and foremost that the CB should not be subject to pressure from the government to finance government activities (deficits) (Epstein, 2006)CB independence implies first and foremost that the CB should not be subject to pressure from the government to finance government activities (deficits) (Epstein, 2006)

11 11 Inflation targeting Inflation targeting is a monetary policy strategy which focuses on only low inflation rates. Inflation targeting is a monetary policy strategy which focuses on only low inflation rates. The focus on inflation means that the CB should not be concerned with other goals such as promoting full employment, supporting industrial policy or allocating credit to the sectors of high priority. The focus on inflation means that the CB should not be concerned with other goals such as promoting full employment, supporting industrial policy or allocating credit to the sectors of high priority.

12 12 Rational behind the inflation targeting stems from the old monetarist argument that in the long run, monetary policy can only affect inflation. However this theoretical tradition depends on invalid assumptions such as neutrality of money. Rational behind the inflation targeting stems from the old monetarist argument that in the long run, monetary policy can only affect inflation. However this theoretical tradition depends on invalid assumptions such as neutrality of money.

13 13 Its expected that inflation targeting will (Epstein,2005); Its expected that inflation targeting will (Epstein,2005); - reduce the rate of inflation, - enhance the credibility of monetary policy, - reduce the sacrifice ratio associated with contractionary monetary policy, - help to attract foreign investment.

14 14 Michael Kumof (2000) stated that the suitability of inflation targeting was first discussed in Masson, Savastano and Sharmas (1997) studies. They find that the policy is unsuitable for most emerging markets (i.e. developing countries), based on two objections: Michael Kumof (2000) stated that the suitability of inflation targeting was first discussed in Masson, Savastano and Sharmas (1997) studies. They find that the policy is unsuitable for most emerging markets (i.e. developing countries), based on two objections: Argument 1: Reduce the rate of inflation

15 15 First: First: for emerging markets the exchange rate remains an important additional objective of monetary policy which is bound to lead to conflicts with the inflation target. for emerging markets the exchange rate remains an important additional objective of monetary policy which is bound to lead to conflicts with the inflation target. Second: Second: inflation targeting may no longer be applicable to all emerging markets what it means for the majority of them is fiscal dominance. inflation targeting may no longer be applicable to all emerging markets what it means for the majority of them is fiscal dominance.

16 16 In the introduction of their research paper, Victor Polterovich and Vladimir Popov argue that considerable number of empirical studies demonstrated that inflation has a negative impact on growth only if it exceeds a certain threshold. Otherwise low inflation has no impact or even accelerates growth (in accordance with the World Banks classification of countries - low income: inflation rate %11-16; lower middle: inflation rate %15-21; upper middle: inflation rate %4-5). In the introduction of their research paper, Victor Polterovich and Vladimir Popov argue that considerable number of empirical studies demonstrated that inflation has a negative impact on growth only if it exceeds a certain threshold. Otherwise low inflation has no impact or even accelerates growth (in accordance with the World Banks classification of countries - low income: inflation rate %11-16; lower middle: inflation rate %15-21; upper middle: inflation rate %4-5).

17 17 Argument 2: Reduce the sacrifice ratio associated with contractionary monetary policy Countries that adopt inflation targeting achieve lower inflation rates by causing recessions and by throwing people out of work (the increase in productivity ???). Countries that adopt inflation targeting achieve lower inflation rates by causing recessions and by throwing people out of work (the increase in productivity ???). Its seen that inflation targeting strategy has been apparent inability to reduce the sacrifice ratio (Epstein, 2005). Its seen that inflation targeting strategy has been apparent inability to reduce the sacrifice ratio (Epstein, 2005). ______________ ______________ Sacrifice ratio: the loss of output or employment associated with a given reduction in inflation (Heintz, 2006) or the unemployment costs of fighting inflation (Epstein, 2005). Sacrifice ratio: the loss of output or employment associated with a given reduction in inflation (Heintz, 2006) or the unemployment costs of fighting inflation (Epstein, 2005).

18 18 Some Problems Originating from the Inflation Targeting Strategy

19 19 Instrument Problem A CB that adopt inflation targeting has only one instrument, namely short-term interest rate. A CB that adopt inflation targeting has only one instrument, namely short-term interest rate. The inflation targeting CBs reduce inflation by raising interest rates because monetary authorities frequently use short term interest rates as a weapon against inflation. The inflation targeting CBs reduce inflation by raising interest rates because monetary authorities frequently use short term interest rates as a weapon against inflation.

20 20 However, this policy leads to an overvaluation of the exchange rate because of the capital inflows. However, this policy leads to an overvaluation of the exchange rate because of the capital inflows. Rising interest rates affect the short term capital flows, as capital flows into a country, the nominal exchange rate appreciates. Rising interest rates affect the short term capital flows, as capital flows into a country, the nominal exchange rate appreciates. Exactly under this strategy, low inflation targets can lead to appreciation of the real exchange rate. This reduces export competitiveness but increases imports (Heintz, 2006). In other words, negative effects occur on net export. Exactly under this strategy, low inflation targets can lead to appreciation of the real exchange rate. This reduces export competitiveness but increases imports (Heintz, 2006). In other words, negative effects occur on net export.

21 21 We know that exchange rate is an important factor in determining inflation rate in developing countries, CB can not be completely free to let the exchange rate float. We know that exchange rate is an important factor in determining inflation rate in developing countries, CB can not be completely free to let the exchange rate float.

22 22 What is recommended by the IMF and the Orthodoxy? Currently recommended by the IMF and the orthodoxy: Currently recommended by the IMF and the orthodoxy: - A fully opened capital account- no capital controls or other restrictions on capital mobility, - A pure floating, market determined exchange rate-non-intervention in the foreign exchange market, -An inflation targeting monetary policy.

23 23 This combination has an important negative attribute (Frenkel,2005): This combination has an important negative attribute (Frenkel,2005): The volatility of capital flows is transmitted through the volatility of nominal and real exchange rates and relative prices with adverse effects on employment and growth. The volatility of capital flows is transmitted through the volatility of nominal and real exchange rates and relative prices with adverse effects on employment and growth.

24 24 The Cost of Accumulating Reserve Another important issue is capital account liberalization and unstable financial flows are needed to increase reserves as protection. Another important issue is capital account liberalization and unstable financial flows are needed to increase reserves as protection. In the absence of any exchange rate target officially stated (because a pure floating exchange rate), the need for holding foreign reserves at the CBs should have been minimal (Epstein and Yeldan,2006). In the absence of any exchange rate target officially stated (because a pure floating exchange rate), the need for holding foreign reserves at the CBs should have been minimal (Epstein and Yeldan,2006).

25 25 Rodrik (2006) stated that developing countries began to accumulate reserves as a consequence of financial liberalization and globalization and the increase in developing countrys reserves is related to changes not in real quantities (such as import or output) but in financial magnitudes. Rodrik (2006) stated that developing countries began to accumulate reserves as a consequence of financial liberalization and globalization and the increase in developing countrys reserves is related to changes not in real quantities (such as import or output) but in financial magnitudes.

26 26 The need for reserve can be explain by the need for liquidity. The need for reserve can be explain by the need for liquidity. Liquidity, in turn, could be achieved via three strategies (Rodrik,2006): Liquidity, in turn, could be achieved via three strategies (Rodrik,2006): - Reducing short-term debt, - Creating a collateralized credit facility, - Increasing foreign exchange reserves of the CBs.

27 27 However accumulating reserves is also costly. However accumulating reserves is also costly. The costs include: The costs include: - The spread between the yield on liquid reserve assets and the external costs of funds, - The sterilization policy causing an increase of interest rates, - Not using this source on the creation of employment or education.

28 28 Dani Rodrik (2006) says that the spread between the yield on liquid reserve assets and the external costs of funds represents the social cost of self-insurance. Dani Rodrik (2006) says that the spread between the yield on liquid reserve assets and the external costs of funds represents the social cost of self-insurance. In his study he calculated this cost is close to 1 percent of GDP. In his study he calculated this cost is close to 1 percent of GDP.

29 29 When CBs attempt to compensate the liquid effect of accumulating reserve, they sterilizing them by selling domestic liabilities from their portfolio may even bid up local interest rates (Frenkel and Taylor,2006). When CBs attempt to compensate the liquid effect of accumulating reserve, they sterilizing them by selling domestic liabilities from their portfolio may even bid up local interest rates (Frenkel and Taylor,2006). So this can cause more capital inflows again and appreciation of exchange rate. So this can cause more capital inflows again and appreciation of exchange rate.

30 30 The Argument of Trilemma The impossible trinity-trilemma says that CBs can only have two out of three of the following options: open capital markets, a fixed exchange rate system and an autonomous monetary policy. The impossible trinity-trilemma says that CBs can only have two out of three of the following options: open capital markets, a fixed exchange rate system and an autonomous monetary policy. In an (internationally) financially integrated economy with high capital flows, monetary policy is bounded only one instrument-short term interest rate. In an (internationally) financially integrated economy with high capital flows, monetary policy is bounded only one instrument-short term interest rate.

31 31 It can be concluded that without any capital control mechanisms or any exchange rate arrangements, a central bank using only short term interest rates can not achieve low inflation rates with a low sacrifice ratio. It can be concluded that without any capital control mechanisms or any exchange rate arrangements, a central bank using only short term interest rates can not achieve low inflation rates with a low sacrifice ratio.

32 32 Low Inflation Rates-For Whom? Low inflation rates or price stability is for whom? Low inflation rates or price stability is for whom? Inflation targeting low inflation rates but high sacrifice ratio, loss of CB credibility. Inflation targeting low inflation rates but high sacrifice ratio, loss of CB credibility. So why the IMF and the Orthodoxy insist on inflation targeting? So why the IMF and the Orthodoxy insist on inflation targeting?

33 33 Epstein and Power (2003) answer this question: Epstein and Power (2003) answer this question: Focus on fighting inflation and keeping it low and stable is in the interest of rentier groups in these countries. Focus on fighting inflation and keeping it low and stable is in the interest of rentier groups in these countries. Who is rentier? Who is rentier? Keynes refers to the rentier as the functionless investor who generates income via his ownership of capital. Keynes refers to the rentier as the functionless investor who generates income via his ownership of capital. Kaleckis definition: it represents the income received by owners of financial firms + the return to holders of financial assets generally. Kaleckis definition: it represents the income received by owners of financial firms + the return to holders of financial assets generally.

34 34 High inflation rates decrease the value of financial wealth. High inflation rates decrease the value of financial wealth. In addition, higher interest rates attract financial flows searching only high gains. In addition, higher interest rates attract financial flows searching only high gains. Financial liberalization and liberalization of the capital account created more financial instability, and thereby, created the need for economic actors to purchase more financial products and create more profits for finance (Epstein and Power,2003). Financial liberalization and liberalization of the capital account created more financial instability, and thereby, created the need for economic actors to purchase more financial products and create more profits for finance (Epstein and Power,2003).

35 35 Epstein and Power (2003) present that in many countries, higher real interest rates and lower inflation increase the rentier shares of income. Epstein and Power (2003) present that in many countries, higher real interest rates and lower inflation increase the rentier shares of income. In a neo-liberal world, the countries are conditioned to adopt and maintain contractionary monetary policies (i.e. inflation targeting) in order to secure investor confidence and international credit worthiness (Epstein and Yeldan,2006). In a neo-liberal world, the countries are conditioned to adopt and maintain contractionary monetary policies (i.e. inflation targeting) in order to secure investor confidence and international credit worthiness (Epstein and Yeldan,2006). So, CBs are independent from government deficits but dependent on investor confidence. So, CBs are independent from government deficits but dependent on investor confidence.

36 36 The case of Turkey

37 37 Central Banking in Turkey Central Bank of Republic of Turkey (CBRT) used to act as an agent of development before the mid 1980s. Central Bank of Republic of Turkey (CBRT) used to act as an agent of development before the mid 1980s. But in the 1990s, like most CBs, CBRT gave its priority to the macroeconomic stability- a combination of price stability and financial stability. But in the 1990s, like most CBs, CBRT gave its priority to the macroeconomic stability- a combination of price stability and financial stability. To achieve the stability objective, CBRT started to use indirect instruments heavily, such as open market operations. To achieve the stability objective, CBRT started to use indirect instruments heavily, such as open market operations.

38 38 In 2001, CBRT announced its independence after a change in its legislation. In 2001, CBRT announced its independence after a change in its legislation. In the period of 2001-2006, CBRT adopted implicit inflation targeting strategy. In the period of 2001-2006, CBRT adopted implicit inflation targeting strategy. In 2006, CBRT announced to adopt explicit inflation targeting. In 2006, CBRT announced to adopt explicit inflation targeting.

39 39 Table 1:Main Macroeconomic Indicators of Turkey (Sources: CBRT and SIS) Indicators200120022003200420052006 CPI inf. (%)68.529.718.49.327.729.65 GNP growth (%)-9.57.95.99.97.66.0 Real XR (1995=100)112.5125.3136.5143.5160.0160.6 T-Bill rate (%)82.362.746.024.716.318.0 Current Account Balance (million $) 3.390-1.524-8.036-15.604-22.824-31.460 Current Account Balance/GNP(%) 2.4-0.8-3.4-5.2-6.4-7.9 Foreign Debt Stock (million $) 113.593129.701144.915160.789168.808206.471 Short Term Foreign Debt Stock (million $) 16.40316.42423.01331.88037.10341.984 FDI (million $)2.7718301.2532.0248.72619.234 CB Reserves (million $) 19.79928.07135.16237.64352.43260.707 Unemployment rate (%) 8.410.310.510.3 9.9

40 40 Assessing the Inflation Targeting Strategy in Turkey

41 41 Years CPI inflation (%) Growth Rate (%) Unemployment rate+ discouraged workers rate (%) 200168.5-9.512.3 200229.77.914.0 200318.45.914.0 20049.329.914.6 20057.727.616.1 20069.656.016.6 Sources:CBRT and SIS Table 2:Inflation, Growth and Unemployment in Turkey

42 42

43 43 Volatility of growth and inflation in Turkey (2001-2006) Volatility of Growth : 1.527 Volatility of Inflation (CPI) : 0.9785

44 44 Annual Sectors2003200420052006 Agriculture1456 Mining147540120 Manufacturing4482147891.395 Services*1969277.69915.813 Other86714112 Total7451.2918.534717.446 * An increase particularly in the financial intermediaries sector Table 3:Foreign Direct Investment Inflow by Sectors in Turkey (Million $) Source: T.R. Prime Ministry, State Planning Organization

45 45 Percentage Share Sectors2003200420052006 Agriculture0.10.30.10.0 Mining1.95.80.50.7 Manufacturing60.116.69.28.0 Services*26.371.890.290.6 Other17.07.90.40.6 Total100.0100.0100.0100.0 * An increase particularly in the financial intermediaries sector Table 4:Foreign Direct Investment Inflow by Sectors in Turkey (%) Source: T.R. Prime Ministry, State Planning Organization

46 46 Years Real XR (1995=100) Current Account Balance (Million $) CB Reserves (million $) 2001112.53.39019.799 2002125.3-1.52428.071 2003136.5-8.03635.162 2004143.5-15.60437.643 2005160.0-22.82452.432 2006160.6-31.46060.707 Table 5: Real Exchange Rate, Current Account Balance and Central Bank Reserves in Turkey Sources: CBRT and SIS

47 47 20052006 Current Account Balance Balance-22824-31316 Capital Originating from Foreign Sources 4038157747 Capital Originating from Domestic Sources -2052-17581 Change in Reserves * -17847-6114 Net Errors and Omission 2342-2736 Net Capital Inflow 4067137430 Net Capital Transmission 1702524708 Foreign Debt Inducing Capital Inflows 2489936011 Foreign Hot Money 1595010512 Domestic Hot Money 787-17325 Net Hot Money Flows 16737-6813 * (-) indicates increase Source: Boratav (2007) Table 6: Main Components of the Balance Of Payments (Million $)

48 48 Conclusion

49 49 Central Bank (CB) policies are of great importance for both developed and developing countries. In the past, we know that many developed countries have used some monetary policy tools to reach development objectives as an important part of their tasks. Now, most developing countries want to adopt a new monetary policy strategy namely inflation targeting which only focus on the price stability. In this strategy, we see that CB operations have changed from using direct instruments to market-based operations like using indirect instruments. Central Bank (CB) policies are of great importance for both developed and developing countries. In the past, we know that many developed countries have used some monetary policy tools to reach development objectives as an important part of their tasks. Now, most developing countries want to adopt a new monetary policy strategy namely inflation targeting which only focus on the price stability. In this strategy, we see that CB operations have changed from using direct instruments to market-based operations like using indirect instruments.

50 50 On the other hand, these new CB policies also raise some problems especially in developing countries, for example rising current account deficits, unemployment and unstable growth rates. These problems are often related to the financial liberalization-unstable financial flows- which eliminates capital controls and exchange rate controls. On the other hand, these new CB policies also raise some problems especially in developing countries, for example rising current account deficits, unemployment and unstable growth rates. These problems are often related to the financial liberalization-unstable financial flows- which eliminates capital controls and exchange rate controls.

51 51 Hence the central banks of developing countries must reconsider the era of globalization and its negative effects on their economies. Hence the central banks of developing countries must reconsider the era of globalization and its negative effects on their economies. They can begin to realize it by accepting that there must be an alternative approach. They can begin to realize it by accepting that there must be an alternative approach. In my opinion, this will be a good starting point for us. In my opinion, this will be a good starting point for us.

52 52 And finally, Thanks to the IDEAs, Tsinghua University and the School of Economics, Renmin University for such a comprehensive organisation Thanks to the IDEAs, Tsinghua University and the School of Economics, Renmin University for such a comprehensive organisationand Thanks to you for your patience. Thanks to you for your patience.


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