1 Stabilising the economy: Central Banks and Monetary Policy MSc EPS Session 4 Hilary term 2013 Professor Dermot McAleese

2 Aim of economic policy is to reduce volatility of market economy time GDP GDP with counter-cyclical policy time GDP without counter-cyclical policy Potential GDP

3 OUTLINE  Price stability defined  Why is price stability important?  Role of Central Bank – a broader remit than price stability?  Monetary policy – objectives and instruments  Effectiveness of monetary policy  New thinking on banking and central banks

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5 Price Stability  a rise in the general level of prices below, but close to, 2% over the medium term (ECB May 2003)  Consumer Price Index (CPI)  Why not CPI target of 0%?  Composition bias  Quality bias  Substitution bias Importance of “medium term” – Bank must not overreact to short term upsurge

6 WHAT CAUSES INFLATION? Inflation is always and everywhere a monetary phenomenon (Friedman)  Demand shocks (property price boom)  Supply shocks (food, energy price increase)  Budget deficit  Money supply, increase in loans

7 ECONOMIC COSTS OF INFLATION pp  Inefficiency effects  Redistributive wealth effects  Adverse dynamics – inflationary spiral  Costly to restore price stability

8 Deflation also a problem Can be even more damaging than inflation Can you explain why? QUESTION FOR CLASS DISCUSSION

9 TASKS OF CENTRAL BANK  Monetary policy  Official foreign reserves  Exchange rate defence  Lender of last resort  Government banker

10 THE CENTRAL BANK Price stability – ultimate objective Intermediate variables to monitor: Money supply Growth of credit Capacity utilisation Commodity prices Order books Exchange rate

11 Speech given by Mervyn King, Governor Bank of England, Belfast 22 January 2013

12 THE CENTRAL BANK (2) Price stability – ultimate objective …. and, by adhering to this objective, Central Bank will make maximum contribution to overall macroeconomic stability.

13 Euro Area’s Money Supply June 2009 (€bn) Currency in circulation Overnight deposits Narrow Money (M1) Short-term Deposits (Quasi-Money) Money Supply (M3) 735 3,505 €4,240 5,190 €9,430bn Memo: GDP 2008 = €9,200 bn Source: ECB Monthly Bulletin M3 at june 2010 is €9,419 bn

14 POLICY INSTRUMENTS OF CENTRAL BANK Open market operations Interest rate Minimum reserve ratio Intervention in forex markets Direct controls Unconventional measures pp

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ECB: main refinancing rate BoE: official bank rate Fed: target rate 16

17 INTEREST RATES AND ECONOMIC ACTIVITY (pp ) THE MONETARY TRANSMISSION MECHANISM

18 MONETARY POLICY AND REAL GDP 1.Substitution effect (-) i  (-) S, (+) C 2. Cash flow (income) effect (-) i  (+) cash flow of borrowers (-) i  (-) cash flow of lenders 3. Wealth effect (-) i  (+) in value of property and equities  (+) C  (+) I 4. Cost of Capital (Investment) effect (-) i  (+) I

19 MONETARY POLICY AND REAL GDP 5. Exchange rate effect (-) i  depreciation of real exchange rate 6. CB credibility effect (-) i  (+) domestic confidence

20 Relax monetary policy Higher money base Lower interest rate Growth in private sector credit More spending Consumer price increase Asset price boost? More output in short run Price stability and Economic Recovery More at work Fig 13.6 p 321 HOW MONETARY POLICY COMBATS DEFLATION

21 Tighten monetary policy Fig 13.6 p 321 HOW MONETARY POLICY COMBATS INFLATION

22 If actual output > potential output, restrictive monetary policy will reduce dangers of inflation Objective is to secure a soft landing ….

23 If actual output < potential output, expansionary monetary policy will reduce danger of deflation Objective is to secure price stability… Need for reflation, or “mild” inflation to solve private debt trap?

24 Limitations of monetary policy in dealing with Deflation Nominal interest rate cannot go below zero (ZIRP) When prices are falling, real interest rate can stay high even as nominal rate falls Hence monetary policy may not have sufficient stimulative impact to combat recession FUNDAMENTAL LIMITATION: expansionary monetary policy encourages spending --- but it cannot force people to borrow and spend (Also potential danger of overstimulus causing inflation)

25 Reform of the Financial Sector also needed 1.“Too big to fail” banks must be taxed to compensate taxpayer for implicit government guarantee: “specific capital surcharges for systemically important financial institutions can be a useful tool and should be accompanied by resolution plans vetted by regulators” (OECD). 2.Structural separation between retail and investment banking also needed 3. Reduce incentive to get too big to fail by taxing the equivalent of the implicit guarantee. 4. Improve supervision and incentives system

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27 Quantitative Easing a)What is it? b) Can it help to restore credit growth?

28 Limitations of monetary policy in dealing with Inflation High nominal interest rate may be needed to curb over optimism and restore balance Danger or over reaction to short term price changes Insufficient attention to asset price movements

29 1.Define price stability. Why is attainment of price stability important? 2. What intermediate targets can a central bank set to ensure that price stability is maintained? 3. What policy actions can a central bank take to preserve price stability? 4. Would a cut in interest rates be an effective way of stimulation aggregate demand in the Euro Area? 5.Does business prefer rising prices (inflation) to falling prices (deflation)? Or are both equally undesirable? Explain. Questions for Group work

30 Exercise 3 p. 304 Questions for Group work (2)

31 CONCLUSIONS  Price stability is good for economic growth  Deflation is just as damaging as inflation  Aggressive monetary policy necessary to avoid booms and busts  But not always sufficient...  In times of crisis, fiscal policy also needed

32 G20 COMMUNIQUE LONDON APRIL 2009 Monetary Policy in Action

33 G20 COMMUNIQUE LONDON APRIL 2009