Centre for Development Studies Monetary Policy and the Role of Central Banks (ECON 5024) Course outline

2012/13 Semester one Course convenor: Professor Campbell Leith Course lecturers: Professor Campbell Leith and Dr Tatiana Kirsanova Brief description This course is a core course for students studying for the MSc / Diploma International Banking and Finance and for the MSc / Diploma Economics, Banking and Finance. The course begins by considering the goals of monetary policy, in the context of developed and developing countries. Contemporary macroeconomic theory is used to define what is achievable through monetary policy. The course then considers the instruments available to the monetary authorities to achieve these aims, and assesses the relative merits of these approaches to the implementation of monetary policy. Next we examine the monetary transmission mechanism. The course concludes by looking at issues in the design of optimal monetary policy institutions, at the time-inconsistency problem and at the desirability of inflation targeting and / or an independent central bank. Aims The main aims of the course are to: Outline the goals of monetary policy. Review the instruments available to central banks for the achievement of these goals. Give an overview of the implementation of monetary policy in practice.

Consider a number of issues relating to the optimal design of monetary policy institutions and the conduct of monetary policy.

Learning objectives By the end of this course, students should be able to: Outline and give a detailed justification of the main goals of monetary policy. Evaluate the ability of different monetary policy instruments to achieve these goals. Review and assess the experience of a range of economies in conducting monetary policy. Explain the difficulties in designing optimal monetary policy and assess alternative solutions to these problems.

Assessment This course is assessed by a combination of end-of-course examination (75 per cent) and in-course assessment (25 per cent). The end-of-course examination is taken in the April/May diet examinations, and takes the form of a two-hour paper, with students being required to answer two questions from a list of four. In-course assessment takes the form of an essay. In Course Assessment Essay Question: Describe the policies of Quantitative Easing pursued by the US Fed and the Bank of England and assess their effectiveness. Would a new round of such policies in either country be as effective as earlier rounds? Essays should be typed, double line spaced, with font size 12. The essay should be no more than 2,000 words in length. Details of the submission procedures and deadline will be provided nearer the time. Penalty for lateness Penalties for late submission of coursework apply. Please refer to the MSc handbook. Teaching methods As there are no tutorials, students are strongly encouraged to make use of e-mails and the lecturers office hours to clarify any points that were not made absolutely clear during the lectures. We may also make use of some of class teaching time to allow students to give informal group presentations on topics covered in the class. Timetable The class will meet for a total of twenty hours during Semester 1. There will be one two-hour lecture weekly for ten weeks. There are no tutorials. Texts/additional reading There is no text recommended for purchase, as no single textbook is appropriate for the whole course. A wide range of reading material will be referred to including relevant journal articles. Detailed reading guides are included below.

Lecture outline Lecture 1: Introduction an overview of issues covered in the course The first lecture will deal with administrative matters and give an overview of the content of this course. Lectures 2-5: The goals of monetary policy These lectures will examine the final goals commonly assigned to monetary policy price stability and contributing to the governments finances. We shall begin by reviewing why contemporary macroeconomic theory suggests that monetary policy should not attempt to boost output, but should, instead, concentrate on stabilising prices. To do so we shall focus on the labour market behaviour underlying the Phillips Curve and consider the role of expectations in defining any trade-off between inflation and unemployment. We shall then consider the role of monetary policy in financing government expenditure, and the implications this has for price stability. Lecture learning objectives At the end of this group of lectures students should be able to: Describe the main goals of monetary policy. Using contemporary macroeconomic theory and empirical evidence, critically assess the motivations for these objectives. Analyse the relative importance of these objectives across different economies.

Suggested reading The Federal Reserve Board of San Francisco publishes a journal Economic Letter on-line at: http://www.frbsf.org/publications/economics/letter/index.html These articles are usually very brief (around 4 / 5 pages) and offer non-technical summaries of recent research by leading economists. They are an excellent starting point for your reading before you consider the more technical material, and it is worthwhile to browse other issues not listed here. Non-technical accounts on the nature of the output-inflation trade-off appear in various issues of Economic Letter: Trehan, B. (1999). Economic activity and inflation, Economic Letter, No. 99-09. Walsh, Carl E. (1998). Nobel views on inflation and unemployment, Economic Letter, No. 97-01; January 10. Walsh, Carl E. (1998). The new output-inflation trade-off, Economic Letter, No 9804, February. Friedmans view of the labour market behaviour implied by the Phillips curve is discussed in: Carlin, W. and Soskice, D. (1990). Macroeconomics and the Wage Bargain, Chapter 3, London: Oxford University Press.

The optimal rate of inflation is discussed in: Cogley, T. (1997). What is the optimal rate of inflation?, Economic Letter, No. 9727. Walsh, Carl E. (1998). Nobel views on inflation and unemployment, Economic Letter, No. 97-01. Marquis, M. (2001). Inflation: the 2% solution, Economic Letter, No. 2001-03. The evolution of the goals of monetary policy in the US is discussed in: Judd, J.P. and Rudebusch, G.D. (1997). The goals of US monetary policy, Economic Letter, No. 97-04. The difference between price-level targeting and inflation-targeting is considered by: Walsh, C.E. (2000). Should central banks stabilize prices?, Economic Letter, No. 2000-24. To understand the link between monetary policy and government finances it is necessary to understand the governments budget constraint. This is discussed in: Mankiw, N.G. (2000). Macroeconomics, 4th edition, Worth Publishers, Chapter 15. Leslie, D. (1993). Advanced Macroeconomics: Beyond IS / LM, McGraw-Hill International (UK) Ltd., Chapter 1. A non-technical paper which deals with the links between monetary policy and government debt and some empirical illustrations of those theories can be found in: Dornbusch, R. (1996). Debt and Monetary Policy: The Policy Issues, National Bureau of Economic Research, Working Paper No. 5573. This is downloadable from http://papers.nber.org/. The importance of the fiscal consequences of monetary policy in developing countries is discussed in: Fry, M.J. (1995). Money, Interest and Banking in Economic Development, The John Hopkins University Press, Chapter 17, Central banks and deficit finance in developing countries. Lectures 6-8: The instruments of monetary policy These lectures will discuss the various direct controls and indirect instruments available to a central bank. We shall examine how each instrument is implemented and we shall examine the relative merits of direct controls in comparison with more market-based approaches. Lecture learning objectives At the end of this group of lectures students should be able to: Describe the main instruments of monetary policy. Analyse the relative merits of these instruments both within and across different economies.

Suggested reading

The Bank of England also publishes a number of fact-sheets on central banking practice which are very useful. These can be downloaded from the Bank of England at: http://www.bankofengland.co.uk/education/ccbs/handbooks/index.htm: Allen, W. (2004). Implementing Monetary Policy, Handbooks in Central Banking, Lecture Series #4, Bank of England. http://www.bankofengland.co.uk/education/ccbs/ls/lshb04.htm Gray, S. and Talbot, N. (2006). Monetary Operations, Handbooks in Central Banking, #24, Bank of England. http://www.bankofengland.co.uk/education/ccbs/handbooks/pdf/ccbshb24.pdf Alexander, W. et al. (1996). Adopting indirect instruments of monetary policy, Finance and Development, vol. 33(1), (March), pp. 14-17. http://www.imf.org/external/pubs/ft/fandd/1996/03/pdf/alexande.pdf Gray, S. et al. (2002). Introduction to Monetary Operations, 2nd edition, Handbooks in Central Banking, #10, Bank of England. http://www.bankofengland.co.uk/education/ccbs/handbooks/ccbshb10.htm IMF (2004). Monetary Policy Implementation at Different Stages of Market Development. http://www.imf.org/external/np/mfd/2004/eng/102604.htm The relative merits of setting interest rates or targeting quantities are discussed in: Schaechter, A. (2001). Implementation of Monetary Policy and the Central Banks Balance Sheet, IMF Working Paper #149. http://www.imf.org/external/pubs/ft/wp/2001/wp01149.pdf The implementation of monetary policy is covered in: Handa, J. (2000). Monetary Economics, Routledge, Chapters 10-12. Lewis, M.K. and Mizen, P.D. (2000). Monetary Economics, Oxford University Press, Chapter 14. Lectures 9-10: The Credit Crunch This lecture will explore the cause of the recent credit crunch and its implications for the conduct of monetary policy. Lecture learning objectives At the end of this lecture students should be able to: Outline the process of securitisation and the leveraged yield trading undertaken by banks. Explain how this contributed to the credit crunch and assess the policy response to this credit market failure.

Suggested reading: An excellent and relatively non-technical book on the crisis is:

Milne, Alistair, (2009). The Fall of the House of Credit, Cambridge University Press. Another book focusing on the personalities involved is: Tett, Gillian, (2009). Fools Gold. How unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe, Little Brown. A thought-provoking book which explores the underlying macroeconomic and political economy causes of the financial crisis is: Rajan, R. G. (2010), Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press. An early empirical analysis can be found in: Taylor, J. and Williams, J. (2008), 'A Black Swan in the Money Market', NBER working paper No. 13943. This paper has been published in the American Economic Journal: Taylor, John B., and Williams. John C. (2009). A black swan in the money market, American Economic Journal: Macroeconomics, 1(1): 5883. An analysis of past crises is given in: Laeven, L and Valencia, F. (2008). 'Systemic Banking Crises: A New Database', IMF Working Paper No. 224, September 2008. The US Feds policy response is detailed on their website: http://www.federalreserve.gov/monetarypolicy/bst.htm and the Bank of Englands policy of Quantitative Easing is detailed at: http://www.bankofengland.co.uk/monetarypolicy/assetpurchases.htm and a detailed comparison of the policies of the US Fed, the ECB and the Bank of England can be found in: Lenza, M, H. Pill and L. Reichlin (2010), Monetary Policy in Exceptional Times, Economic Policy, April 2010, pp 295-339. A brief summary of work assessing the impact of quantitative easing can be found at: Williams, J. (2011), Unconventional Monetary Policy: Lessons from the Last Three Years, FRBSF Economic Letter, No. 2011-31. And a summary of a Bank of England conference on unconventional monetary policy which details some of the policies pursued in the US Fed, ECB and Bank of England: Joyce, M. (2012), Quantitative Easing and Other Unconventional Monetary Policies: Bank of England Conference Summary, Quarterly Bulletin, Q1, pp 48-55. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb120104 .pdf

Moving from direct controls to a market based system In previous years we looked at the issues that arise when developing economies attempt to move from a system of direct to indirect, market-based controls for the conduct of monetary policy. We also examined the empirical evidence on the viability and success of alternative approaches. However, due to the increased attention paid to the financial crisis and the fact that most economies have moved towards the use of indirect instruments, we shall no longer teach or examine this topic. Nevertheless, the suggested reading materials are given below just in case they are of interest. Suggested reading IMF (2004). Monetary Policy Implementation at Different Stages of Market Development. http://www.imf.org/external/np/mfd/2004/eng/102604.htm. Schaechter, A. (2001). Implementation of Monetary Policy and the Central Banks Balance Sheet, IMF Working Paper #149. http://www.imf.org/external/pubs/ft/wp/2001/wp01149.pdf. Alexander, W. et al. (1996). Adopting indirect instruments of monetary policy, Finance and Development, vol. 33(1), (March), pp. 14-17. Other potential sources of material: Honohan, P. and OConnel, S.A. (1997). Contrasting Monetary Regimes in Africa, IMF Working Paper No. 97 / 64, May 1997. Wagner, H. (1997). Central Banking in Transition Economies, IMF Working Paper No. 98 / 126, August 1997. The Development of Bond Markets in Emerging Economies, BIS Papers No. 11. Lectures 11 14: From instruments to goals the monetary policy transmission mechanism Having outlined both the aims and instruments of monetary policy, we shall turn to the link between the two the monetary policy transmission mechanism. We shall also examine the role of intermediate targets. In addition, we shall study the impact that the recent financial crisis had on the transmission mechanism, and the transmission mechanism of unconventional monetary policies. Lecture learning objectives At the end of this group of lectures students should be able to: Provide a detailed analysis of the linkages between monetary policy instruments and the goals of monetary policy. Understanding the impact that the financial crisis had on the monetary policy transmission mechanism. Understanding the policy transmission mechanism of unconventional monetary policies.

Suggested reading

Information on the monetary policy transmission mechanism is published by: Bank of England Monetary Policy Committee (1999). The transmission mechanism of monetary policy. This can also be found at the Bank of England's website at: http://www.bankofengland.co.uk/publications/other/monetary/montrans.pdf and it considers both the theoretical and empirical aspects of the transmission mechanism. See also the HM Treasury study EMU and the monetary transmission mechanism, Chapter 2, for a review of the theory of the Transmission Mechanism, and Chapter 4 for a comparison of differences across countries. http://www.hmtreasury.gov.uk/documents/international_issues/the_euro/assessment/studies/euro _assess03_studhampshire.cfm Other papers relevant to the monetary transmission mechanism can be found in Symposium on the Monetary Transmission Mechanism, Journal of Economic Perspectives (1995), vol. 9(4). In particular see the papers by: Taylor, J.B. (1995). The monetary transmission mechanism: an empirical framework. Bernanke, B.S. and Gertler, M. (1995). Inside the black box: the credit channel of monetary policy transmission. Another paper which examines the transmission mechanism is: Taylor, M.P. (1999). Real interest rates and macroeconomic activity, Oxford Review of Economic Policy, vol. 15(2), pp. 95-113. A paper on the evolution of the monetary policy transmission mechanism: Boivin, J., Kiley MT and Mishkin, F.S. (2010) "How Has the Monetary Transmission Mechanism Evolved Over Time?," NBER Working Papers 15879. Papers on the financial crisis, unconventional monetary policies and their transmission mechanism: Cecchetti, S. (2009) Crisis and responses: the Federal Reserve in the early stages of the financial crisis Journal of Economics perspectives, vol 23(1), pp 51-75. This paper uses the balance sheet of the Federal Reserve to demonstrate the differences between conventional and unconventional monetary policies. Benford, J., Berry, S., Nikolov, K., Young, C. and Robson, Mark (2009). Quantitative easing Bank of England Quarterly Bulletin, pp 90-100. This article outlines the three main transmission channels for QE. Joyce, M.,Lasaosa, A., Stevens , I. & Tong, M., (2010) "The financial market impact of quantitative easing," Bank of England working papers 393. This paper details the impact of QE through the asset pricing channel. Meier, A. (2009). Panacea, Curse, or Nonevent? Unconventional Monetary Policy in the United Kingdom. IMF Working Paper 09/163. This paper outlines a range of unconventional monetary policy options, and the transmission channels and risks associated with each. It also focuses on the BoEs specific policies and their

effectiveness. Borio, C. and Disyatat, P. (2010) Unconventional Monetary Policies: An Appraisal, Manchester School, 78(s1), pp. 53-89. This paper provides a technical description of unconventional monetary policies (i.e. the balance sheet policies) and their transmission mechanism. European Central Bank (2010) The ECBs Response to the Financial Crisis. ECB Monthly Bulletin, pp 59-74. This paper provides an overview of monetary policy transmission in the Euro Area in normal times and the effect of the financial crisis had on the transmission channels. It also provides the ECBs assessment of their response to the crises. Lectures 15-16: How central banks behave in practice - case studies The lectures so far will have developed a basic framework for analysing the conduct of monetary policy. These lectures will utilise this framework to examine the practice of a number of central banks from both developed and developing countries. We shall also examine the empirical evidence on the transmission mechanism for a range of countries. Lecture learning objectives At the end of this group of lectures students should be able to: Provide a detailed review of the actual conduct of monetary policy in a number of developed, developing and emerging economies. Explain the differences in the conduct of monetary policy in the light of the discussion of the links between goals and instruments undertaken above.

Suggested reading As a framework for comparing the actual setting of interest rates in the US, Japan and Europe we shall examine the econometric approach of: Clarida, R., Gali, J. and Gertler, M. (1998). Monetary policy rules in practice: some international evidence, European Economic Review, vol. 42(6), (June), pp. 10331068. For a discussion of Taylor Rules: Orphanides, A. (2007) Taylor Rules. The New Palgrave: A Dictionary of Economics. Second Edition http://www.athanasiosorphanides.com/taylor22f.pdf In this subsection a relevant article from the journal describing US monetary policy is: Economic Research Department, (1999). US monetary policy: an introduction, FRBSF, Economic Letter, No. 99-01. Marquis, M. (2002). Setting the interest rate, Economic Letter, No. 2002-30. The African case is dealt with in: Honohan, P. and OConnel, S.A. (1997). Contrasting Monetary Regimes in Africa, IMF Working Paper No. 97 / 64, Pay 1997.

A comparison of the US, Japan and the Euro-area is given in: Monetary and Economic Department (2001). Comparing Monetary Policy Operating Procedures across the United States, Japan and the Euro-Area, BIS Papers No. 9. Lecture 17: Understanding monetary statistics This lecture will provide students with a guide to official monetary statistics. Lecture learning objectives At the end of this lecture students should: Have knowledge of the usefulness of a range of standard monetary statistics. Explain the role of economic models in implementing monetary policy.

Suggested reading The core reading for this lecture is the Centre for Central Banking Studies Handbook: Thorp, J. and Turnbull, P. (2000). Banking and Monetary Statistics, Centre for Central Banking Studies Handbook in Central Banking. We shall also discuss the use of models in implementing monetary policy: Price, L. (1996). Economic Analysis in a Central Bank Models versus Judgement, Centre for Central Banking Studies, Handbook in Central Banking No. 3. We shall then examine the practice in the Bank of England as a case study. The range of models employed by the Bank of England is discussed in: Economic Models at the Bank of England, (1999 and updated 2000). Pub. Bank of England. Downloadable from the Bank of Englands website, http://www.bankofengland.co.uk and http://www.bankofengland.co.uk/publications/other/beqm/models00.pdf. We shall also examine the Pagan reports into the use of such models at the Bank: Pagan, A. (2003). Report on Modelling and Forecasting at the Bank of England. Downloadable from http://www.bankofengland.co.uk/publications/news/2003/paganreport.pdf. Lecture 18-20: Other issues in monetary policy design In these lectures we shall look at the problem of time-inconsistency. In other words, even if policy makers accept the desirability of price-stability, they may have incentives to renege on their promises to act accordingly. We shall also look at possible solutions to these problems, and review the evidence on the success of these solutions. We shall also examine the implications for monetary policy of interactions between monetary and fiscal policy. Lecture learning objectives At the end of these lectures students should be able to: Outline the problem of time-inconsistency as it applies to monetary policy. Critically evaluate solutions to this problem.

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Assess the importance of monetary and fiscal policy interactions. Comment on the optimal design of monetary policy institutions in different economies.

Suggested reading For time inconsistency: Beddies, C.H. (2000). Selected Issues Concerning Monetary Policy and Institutional Design for Central Banks: A Review of Theories. IMF Working Paper # 00 / 140. Carlin, W. and Soskice, D. (2006). Macroeconomics: Imperfections, Institutions and Policies, Oxford University Press, Chapter 5, Monetary Policy. http://www.oup.com/uk/orc/bin/9780198776222/carlin_chap05.pdf Walsh, C. (2003). Modern Central Banking: An Academics Perspective. http://people.ucsc.edu/~walshc/MyPapers/ModernCentralBankingfinal.pdf For the interaction between monetary and fiscal policy: Balls, E. and ODonnell, G. (2002). Reforming Britains Economic and Financial Policy, Chapter 5, Policy coordination, HM Treasury. HM Treasury (2003). Policy Frameworks in the UK and EMU, Chapter 5, Policy Coordination. http://www.hm-treasury.gov.uk/media/0/1/adsur03_4567ra_289.pdf Bhundia, A. and ODonnell, G. (2002.) UK policy coordination: the importance of institutional design, Fiscal Studies, vol. 23(1), (March), pp. 135-164. The three papers listed above were produced by the previous UK Government. The material on fiscal and monetary policy coordination remains relevant; however the wider discussion on the UK Governments fiscal policy framework and targets is now out of date. For an overview of the new UK Governments fiscal framework and objectives, please see: HM Treasury - Budget 2010 (pp 11-13) http://cdn.hm-treasury.gov.uk/junebudget_complete.pdf HM Treasury - Charter for Budget Responsibility (Chapters 3 and 4) http://www.hm-treasury.gov.uk/d/charter_budget_responsibility040411.pdf IFS Green Budget Charter 2 - The new fiscal framework: an assessment http://www.ifs.org.uk/budgets/gb2011/11chap2.pdf Nordhaus, W. (1994). Policy games: coordination and independence in monetary and fiscal policies, Brookings Papers on Economic Activity 2, pp. 139-216. For a discussion of different nominal anchors and inflation targeting: Batini, N., Kuttner, K. and Laxton, D. (2005). Does inflation targeting work in emerging markets?, IMF World Economic Outlook, Sept 2005. http://www.imf.org/external/pubs/ft/weo/2005/02/pdf/chapter4.pdf. Bernanke, B. et al. (1999). Inflation Targeting: Lessons from the International

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Experience, Princeton (pp. 301-307 on other nominal anchors). Kahn, M.S. (2003). Current Issues in the Design and Conduct of Monetary Policy, IMF Working Paper # 03 / 56. http://www.imf.org/external/pubs/ft/wp/2003/wp0356.pdf. For other material on this topic: A comprehensive, yet readable, review of the literature discussing the credibility of monetary policy announcements under rational expectations (time consistency / inconsistency) is given in: Lewis, M.K. and Mizen, P.D. (2000). Monetary Economics, Oxford University Press, Chapter 10. A summary of recent research on time-inconsistency is given by: Dennis, R. (2003). Time-inconsistent monetary policies: recent research, FRBSF, Economic Letter, No. 2003-10. Transparency and monetary policy is discussed in: Walsh, C.E., (2000). Uncertainty and monetary policy, Economic Letter, No. 200008. Walsh, C.E. (2001). Transparency in monetary policy, Economic Letter, No. 200126. Issues relating to applying inflation targeting in developing countries are dealt with in: Carare, A., Schaechter, A., Stone, M. and Zelner, M. (2002). Establishing Initial Conditions in Support of Inflation Targeting, IMF Working Paper 20 02 / 102, June 2002. The experience of developing economies adopting inflation targeting is reviewed in: Carare, A. and Stone, M.R. (2002). Inflation Targeting Regimes, IMF Working Paper 03 / 09, January 2003.

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