Monetary Policy and Inflation

Chapter 29 & 30

Monetary Policy

Channel of Monetary Policy

When the central bank increases the monetary base, the money supply will increase. Banks have excess liquidity which they use to make more loans. The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate.

Dynamics of Monetary Transmission

Money supply expansion reduces interest rates Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods. Lower interest rates increase demand for US$ in forex market depreciating the exchange rate. Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

Monetary Transmission Mechanism

ECB Web Site

Monetary Policy: Money Supply Expands

Money Supply

Money
Supply
i*
1

i**
2

Money Demand

Expansionary Monetary Policy

I C, NX

AD

AD Y

An Expansionary Cycle Driven by monetary policy

P
3 YP

1. Economy at LT YP.
2. Monetary Policy Cuts Interest Rate

SRAS
2

P*
1

3. Investment rises. The AD curve shifts out.

AD AD
Output Gap

4. Tight labor markets. SRAS returns to long run equilibrium

Monetary Policy Short-term vs. Long Term

In the short-run, expansionary monetary policy can boost economic growth. But in the long-run, expansionary monetary policy only leads to rising prices (i.e. inflation).

Interest Rate Management

In most economies around the world, the central bank does not simply act to maintain a fixed money supply. Rather, they adjust money supply to maintain and manage interest rate changes in response to business cycle conditions.

Monetary Policy
In the US (and Euroland and Japan and most OECD economies), the central bank sets monetary policy by picking a short-run interest rate they would like to prevail. In HK, the central bank sets monetary policy by picking a fixed exchange rate.

U.S. Central bank cuts interest rates during recessions

Demand Driven Recession w/ Counter-cyclical monetary policy

P AD
1 3

YP

SRAS

1. Economy in a recession. Fed detects deflationary pressure

2. Monetary Policy Cuts Interest Rate 3. Investment increases spending to shift the AD curve back to long run equilibrium

P*
2

AD
Gap < 0

Demand Driven Expansion w/ Counter-cyclical monetary policy

P
YP

SRAS
2

1. Economy in expansion. Fed detects inflationary pressure

2. Monetary Policy Raises Interest Rate 3. Investment decreases spending to shift the AD curve back to long run equilibrium

P*
1 3

AD

AD
Gap > 0

Price Stability
Counter-cyclical monetary policy stabilizes output near potential output, YP, but also stabilizes the price level near P*. Central banks may pursue price stability as a goal and also stabilize output as well if business cycles are caused by demand shocks.

Policy Framework Price Stability

Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates ECB Objective The primary objective of the ECBs monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

The Great Moderation

The Great Moderation by Federal Reserve Bank of Dallas

Taylor Rule
Economist named John Taylor argues that US target interest rate is well represented by a function of
1. current inflation 2. Inflation GAP: current inflation vs. target inflation 3. Output Gap: % deviation of GDP from long run path

Function: Inflation Target * = .02

TGT t

.025 t

( t ) 1 2 Output Gapt
*

The Taylor Rule Download

What should be the current Fed Funds rate? Will they be increasing it soon?
Step 1. Find Inflation Rate Step 2. Find Output Gap Step 3. Calculate Taylor Rule implied rate and compare with current rate.

Answer
P_2008_2 P_2007_2 Inflation Y YP Output Gap Inflation Gap Taylor Rule Fed Funds Rate 121.91 120.00 0.016 11740.3 11904.0 -0.014 -0.004 0.032 0.02

Stagflation w/ Counter-cyclical monetary policy

P
P**
2

1. Economy experiences stagflation

2. Monetary Policy Cuts Interest Rate 3. Investment increases spending to shift the AD curve to long run equilibrium with higher prices.

YP
3

SRAS

P*

AD
AD

Stagflation w/ Price Stabiliztion

P
2 3

1. Economy experiences stagflation

YP

SRAS

2. Monetary Policy Raises Interest Rate 3. Investment decreases spending to shift the AD curve to equilibrium with lower output.

P*

AD

AD

Monetary Policy and Supply Shocks

In the face of demand shocks, no trade-off between price and output stability. In the face of supply shocks, such a tradeoff exists.

Question: Problem with Central Bank Stabilization

Situation: Economy is in long-run equilibrium, but central bank overestimates potential output. Draw outcome if central bank believes that the potential output is higher than it is.

A Bias toward Expansionary monetary policy

P
YP
5 4

1. Central Bank repeatedly expands the money supply 2. Inflation recurs

P*

SRAS
1

SRAS
YPhantom

AD AD Y

Monetary Policy Lags

Counter-cyclical fiscal policy beset by lags between the time a recession is recognized and the time the government can form consensus to act. Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates.

Inflation

Quantity Theory
Simplest monetary theory is the Quantity Theory of Money.
Purchasing power of money is equal to the quantity of money (Mt) times the speed of circulation (V, # of transactions) Purchasing power means # of goods (Yt) multiplied by price per good (Pt)

Moneyt * Velocity = Pt * Yt

Rule of Thumb
Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Z t X t Yt g g g
Z t X t
Z t

Y t

Z t Z t 1 g Z t 1

Money and Inflation

Assuming stable velocity

g g t
M t Y t

t g

P t

Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

Money & Inflation: 1975-1994

Inflation & Money OECD Countries
0.2 0.18 0.16

Average Inflation Rate

0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 Average Money Growth

Ex Ante Rate and the Fisher Effect

Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate. Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the markets consensus forecast of inflation.

it rt

EA

FORECAST t 1

Great Inflation of the 1970s

US Inflation Rates & Interest Rates
18.00 16.00 14.00 12.00

10.00 8.00 6.00 4.00 2.00 0.00

Interest Rates Inflation

Mar-55

Mar-58

Mar-61

Mar-64

Mar-67

Mar-70

Mar-73

Mar-76

Mar-79

Mar-82

Mar-85

Mar-88

Mar-91

Mar-94

Mar-97

Mar-00

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Great Inflation Download

Mar-03

Fisher Effect: OECD Economies Great Inflation of 1970s

20 18 16

Interest Rates-1984

14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 14 16 18 Average Inflation 1970-1984

Loanable Funds Market

Fisher Effect

i*
r*

E t 1

tE 1

LF*

I LF

Ex Ante vs. Ex post

We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation.

rt

ExP

it

ACTUAL t 1

The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return. ExP ExA FORECAST ACTUAL

rt

rt

t 1

t 1

Unexpected Inflation Winners and Losers

Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers. Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are winners/borrowers are losers.

Inflation Risk
When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers. High inflation rates tend to be associated with unpredictable inflation.

Costs of Anticipated Inflation

Shoe Leather Costs Money is a technology for engaging in transactions. The greater is inflation, the greater the cost for individuals of holding money. Individuals must make efforts as a substitute for the convenience of holding money. Menu Costs Firms must engage in costs of changing posted prices. More generally, when prices change rapidly over time, more time and effort must be put into calculating relative prices.

The Inflation Tax

Banknotes do not pay interest. The real interest rate on banknotes is

rt

CASH

t 1

If inflation is high, currency has sharply negative returns. People will avoid holding money leading to society losing the convenience of money transactions.
Zimbabwe Inflation Download

Causes of Extremely Rapid Inflation

Government generates revenues by printing new money (referred to as seignorage). Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money. Explain the link between deficits and inflation.

100

150

200

250

300

350

400

50 Inflation

Israel 1970-1990

19 70 19 71 19 72 19 73 19 74 19 75 19 76 19 77 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90

Israel 1970-1990
Surplus (% of GDP) 5.00%

0.00%

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

-5.00%

-10.00% -15.00%

-20.00% -25.00%

-30.00%

1990

A Bias toward Expansionary monetary policy

P
YP 5 4

1. Central Bank repeatedly expands the money supply 2. Inflation recurs

3. After a time, as inflation becomes expected it will cease to impact output even in the short run.

P*

SRAS

2 1

SRAS

AD AD
Inflationary Gap

Features of Inflation Targeting

A medium term communication strategy
Commitment to price stability as goal of monetary policy. Clear statement of numerical target for inflation over the medium (1-2 year) term. Communication with public about current forecasts of inflation and policy actions used to achieve target. Central Bankers accountable for achieving goals.

Yield Curve
The yield curve is the gap between the interest rate on long-term bonds and shortterm bonds. When long-term interest rates are high relative to the short-term interest rates, the yield curve is steep. When short-term interest rates are relatively high, the yield curve is flat or inverted.

Monetary Policy and the Yield Curve

Central bank expands the money supply and short-term interest rate will fall. Negative effect on long term real interest rate but Also likely to increase inflationary expectations raising nominal long-term interest rates. Yield Curve steepens when money supply expands and flattens when money supply contracts.
Yield Curve Download

0.5 1 2 3 4 5

1.5

2.5

3.5

4.5

0 10 Year 3 month Yield Curve

US Yield Curve September 2007: Expansionary Monetary Policy

9/ 4/ 20 07 9/ 6/ 20 07 9/ 8/ 20 07 9/ 10 /2 00 9/ 12 7 /2 00 9/ 7 14 /2 00 9/ 7 16 /2 00 9/ 7 18 /2 00 9/ 7 20 /2 00 9/ 22 7 /2 00 9/ 7 24 /2 00 9/ 7 26 /2 00 9/ 7 28 /2 00 7

Learning Outcome
Calculate the impact of inflation on longterm nominal interest rates using the theory of the Fisher effect. Calculate real return on debt as a function of inflation and expected inflation. Calculate real return on money as a function of inflation.