Chapter 5 Monetary policy.doc

1、Monetary policy: theory and practice by Peter Dawson Introduction Monetary policy has been at the forefront of government thinking about the workings of the economy for the last 30Monetary policy has been at the forefront of government thinking about 7.he workings of the economy for the last 30years

2、. Together with fiscal policy it is one of the main methods governments employ in the pursuit of their economic objectives of high economic growth, low unemployment and low w-d stable inflation. Traditionally monetary policy has been conducted by central banks on behalf of governments. This means th

3、at although the central bank implements monetary policy it is the government which makes the final decision about the timing and the magnitude of the change. Recently governments in a number of countries have granted varying degrees of independence to central banks. In the UK, for example, the Bank

4、of England (BoE) was given operational independence in 1997 granting it a degree of discretionary power in the setting of interest rates and other monetary variables. The importance of monetary policy can be found in the increased media interest in monetary policy matters. Barely a day goes by witho

5、ut some mention of monetary policy Newspapers are filled with speculation about the likely moves monetary authorities will take in order to stabilise the economy Remarkably there is now broad agreement amongst economists that monetary policy is the only policy tool capable of reducing business-cycle

6、 fluctuations. However, this does not mean that monetary policy is no longer considered to be controversial. There is still disagreement amongst economists and central bankers over how it should be implemented and who should control it. This chapter addresses three fundamental questions. First, what

7、 is the role 3Ild purpose of monetary policy; what is it used for and how does it affect the workings of the economy? Next, how is monetary policy implemented? For example, what is the procedure by which monetary policy is conducted? Third, and finally should governments or central banks have ultima

8、te responsibility for monetary policy? The objectives of monetary policy To understand the role and purpose of monetary policy requires an understanding of what monetary policy actually means. The standard textbook definition describes monetary policy as actions taken by monetary authorities to affe

9、ct monetary and other financial conditions in pursuit of the broader objectives of sustainable growth of real output, high employment and price stability (Lindsey and Wallich, 1989). The monetary authorities in the UK are the Bank of England (BoE) and the Treasury There is little doubt that the mone

10、tary authorities would like sustained economic growth because it increases the economys output of goods and services over time and increases the standard of living of its citizens. However, growth is unlikely to be sustained if it is not stable. The reason for this should be clear: consumers and fir

11、ms are unlikely to make long-term investment plans because they will be unwilling to undertake the risks associated with an unstable economy. Economic growth is closely related to employment. If there is high unemployment then there will be unused resources (workers, machinery and factories) in the

12、economy resulting in a loss of output. Needless to say firms will not undertake any capital investment programmes when there is spare capacity Nevertheless, this is not to say that the goal should be a zero rate of unemployment. Employment should be at a level whereby the amount of labour demanded i

13、s equal to the amount of labour supplied (the full employment or natural rate of unemployment level). The monetary authorities are also interested in maintaining price stability Price stability in a market economy is desirable because it conveys information about resource allocation. High inflation

14、in particular makes it especially hard to plan for the future because high inflation is synonymous with uncertain inflation, and evidence suggests that this has a detrimental effect on economic growth (see for example, Barro, 1995). As a result it is widely accepted that low and stable inflation is

15、the key objective of monetary policy. In addition, the belief that it was possible to raise output and employment by accepting a higher level of inflation as depicted in the celebrated Phillips curve no longer exists (in the long-run, anyway). How do the monetary authorities go about achieving price

16、 stability? This would be relatively straightforward if they could control inflation directly Unfortunately they cannot. What they can do is try and manipulate the financial system by seeking to control one or a number of monetary variables which they believe to have an important influence on price

17、stability These variables are called the intermediate targets of monetary policy and include such things as the money supply and the exchange rate. Unfortunately the intermediate targets cannot be controlled directly Consequently, the monetary authorities use operating targets - such as short-term i

18、nterest rates and the amount of reserves held by 1 The debate over whether the authorities should pursue price stability or inflation stability has attracted increasing attention in recent years (see for example the references cited in Cecchetti, 2000). Price stability implies that the authorities h

19、ave to address previous failures to meet the target whereas with an inflation rate target it does not. The implication of this is that a price stability target will create more certainty in the long-run - because the authorities are obliged to return to the target path for prices - but more variabil

20、ity in the short-run: if the inflation rate this year is 4% but the target rate is 2.5% then the goal this year will be less than 2.5%. banks - which are directly controlled by the monetary authorities and are closely related to the intermediate targets. Finally in order to achieve their operating t

21、argets the monetary authorities use the various monetary policy instruments at their disposal. The most common instruments are often market operations, discount policy. and reserve requirements. The linkages between the goals, targets and instruments are represented schematically in Figure 1. What m

22、atters in terms of monetary policy is the reliability of these linkages. This diagram and the elements within it form the basis of the discussions that follow in this chapter. Figure I Monetary policy: processGoal variableIntermediate target Operating targetPolicy instrumentThe monetary transmission

23、 mechanism The formal analysis of how monetary policy influences spending and prices is called the monetary transmission mechanism. As noted in the previous section, the monetary authorities use policy instruments, which are directly under their control, to change short-term interest rates and the m

24、oney supply to. ultimately enable them to achieve their goal of price stability A more thorough discussion of the instruments and targets at the authorities disposal will occur later. The objective of this section is to analyse how changes in the financial system translate into changes to the real e

25、conomy or, to put it another way how changes in interest rates and prices of financial assets influence investment and spending decisions. Money supply and demandThe purpose of using an instrument is that it will create a shock or disturbance in the financial system, in other words it disturbs equil

26、ibrium, by changing either a price variable or a quantity variable. The most common price variable is the rate of interest (cost of borrowing) and the most common quantity variable :s the quantity of money (supply of money). These components are modelled within the money market. In constructing the

27、money market it is common practice in most textbooks to assume the money supply schedule is directly under the control of the authorities. Diagrammatically this enables the supply curve to be presented as a vertical line (i.e. perfectly inelastic). In truth the money supply is never fully under the

28、control of the authorities. The reason for this is it is partly determined by the behaviour of banks and their customers. However, the assumption of a completely con1rolled money supply schedule does not lose the generality of the analysis presented here. The demand for money reflects the three diff

29、erent motives for holding money as stipulated by John Maynard Keynes in his celebrated 1936 book, The General Theory of Employment, Interest and Money. These motives are transaction. precautionary and speculative. In Keynes terminology; the demand for money is known as liquidity preference theory be

30、cause when an individual is holding money they are expressing a preference for the liquidity that holding money brings with it. Transaction demand arises from the function of money as a medium of exchange in that it enables individuals to purchase every day goods and services. such as food for lunch

31、 and petrol for the car. Keynes emphasised that the transaction motive for holding money increases as income increases. Because we live in an uncertain world, individuals are likely to hold money as a precaution against unexpected occurrences. For example, you may hold money as a precaution against

32、an unexpected car repair bill or if a previously expensive item of clothing that you wanted suddenly becomes massively reduced in a sale. The precautionary demand, like the transaction demand. increases as income increases. Keynes third and crucial motive was based on the fact that as well as a medi

33、um of exchange, money is also demanded as an asset - in other words as a store of wealth. Keynes called this motive the speculative demand. Keynes argued that the speculative demand too was positively related to income but in addition was negatively related to interest rates2. He explained this by a

34、ssuming there were only two types of asset - money (the most liquid of assets), and bonds (to represent all other financial assets). Individuals would then determine how much money they would hold on the basis of their expectations of future movements in interest rates. If, for example, individuals

35、expect interest rates to fall then given that the interest rate payable on bonds issued in the past are fixed, the expected fall in interest rates will increase the attractiveness of bonds, more people will wish to buy them and their price rises. In addition, those that already hold bonds will make

36、a capital gain when interest rates fall. If interest rates are above the perceived normal level, individuals will expect a fall in the near future and so they will buy bonds and hold less money. Adding these three motives together gives us a downward-sloping money demand schedule (Md0) and if we add

37、 this demand schedule to the perfectly inelastic supply schedule (Ms0) we obtain an equilibrium price of i0 and an equilibrium quantity of q0 (Figure 2). If we now consider an expansionary or contractionary shock then the interest rate will change. For example consider an expansionary shock. The mon

38、etary authorities can achieve such an expansion by increasing the money supply; say to Ms1. This would lead to an excess supply of money, which would require a fall in interest rates from i0 to i1 in order to restore equilibrium. This mechanism can also work in the opposite direction. In this case,

39、instead of a change in the money supply to control interest rates we have a change in the interest rate to control the money supply. 2. Baumol (1952) and later Tobin (1956) argue that the transaction motive and the precautionary motive for holding money are also negatively related to interest rates.

40、 The reasoning behind this was that although by holding money individuals could avoid the problems of transaction costs, there is an opportunity cost in the form of interest that could be earned on other assets. As the rate of interest, and therefore the opportunity cost of holding money increases,

41、individuals will reduce the amount of money they hold for transaction and precautionary purposes. 17Figure 2Monetary policy and the economyA critical question for the monetary authorities is how changes in money supply and interest rates affect the real economy? Only by understanding the mechanisms

42、through which monetary policy affects the economy will the authorities be successful in the conduct of monetary policy According to Keynes this fall in interest rates has the effect of increasing business investment through the lower cost of borrowing. Spending on consumer durables (houses, cars and

43、 white goods) also increases because saving is now less attractive because the opportunity cost of money is lower. In addition the fall in interest rates results in a rise in value of financial assets (bonds) adding a further stimulus to consumption via its effect on wealth and to investment by lowe

44、ring the cost of capital. The monetarist story is somewhat different. Monetarists argue that tile excess supply of money induced by the monetary authorities or brought about via a reduction in interest rates means that individuals find they have more money than they need for normal spending. These c

45、onsumers may decide to spend some of this money on a much wider range of financial and real assets than Keynes had originally postulated. In terms of financial assets this would, as before, include bonds but also shares and other financial assets such as derivatives. The increased demand for these a

46、ssets will increase their price, so that those that already own such assets will find that the value of their financial wealth increases. And if the assumption that individuals wish to spread the amount they spend over time - life-cycle spending hypothesis - holds they may well increase current cons

47、umption. Investment is also boosted, as before, via the reduction in the cost of capital. Although both approaches come to similar conclusions they differ in their nomination of the key variable. In the standard Keynesian approach interest rates are key whereas in the Monetarist approach it is the m

48、oney supply As well as the cost of borrowing, wealth and the effect on asset prices, and because the UK conducts a large amount of trade with other countries, consideration must be given to how monetary policy affects the exchange rate. Looking at the impact on the exchange rate is important because

49、 this will affect the amount of overseas expenditure and investment relative to domestic expenditure and investment undertaken. Maintaining our discussions in terms of an expansionary monetary policy consider the following. As before we have a reduction in interest rates. This time consumers and fir

50、ms in the UK and overseas will sell UK assets and purchase overseas assets because the relative interest rates on overseas assets are higher than those currently available on domestic assets (we are, of course, assuming that the reduction in interest rates in the UK is not matched by a reduction in

51、interest rates overseas). Consequently in order to purchase these overseas assets consumers and firms will sell pounds in order to buy foreign exchange in order to purchase overseas assets. This leads to a fall in the value (depreciation) of the pound, which makes UK goods more attractive to oversea

52、s buyers, and therefore increases export sales. However such a mechanism only works when the exchange rate is flexible (allowed to change). If the exchange rate is fixed, such as when the UK was a member of the European Exchange Rate Mechanism (ERM), there will still be a net outflow of funds but th

53、e exchange will be unchanged. It cannot be over-emphasised that the mechanisms described above will not affect the real economy instantaneously: Indeed there are significant time-lags involved. Both Monetarists and Keynesians agree that monetary policy can have an effect on output in the short-run,

54、but the only lasting effect is on prices. A standard rule of thumb has developed in the literature which states that policy tends to have its full effect on output within about one year, and on inflation in around two years, see, for example, Lane and Van Den Heuvel (1998). Some of the problems gene

55、rated in the past arose because the authorities incorrectly believed that monetary policy had long-term effects on output. In recent years these so-called traditional monetary transmission mechanisms have come under attack from two groups. The first group contend that monetary policy is ineffective

56、even in the short-run because individuals have rational expectations. Proponents of this view - the New Classical School- developed by Robert Lucas and Thomas Sargent among others, argue that because individuals use all information available to them they will quickly learn how monetary policy is bei

57、ng co-ordinated by the monetary authorities. Consequently they will learn to anticipate what the authorities are likely to do next, thereby neutralising the (short- run) real effects of the policy: As will be demonstrated later, this has important implications both in terms of how the authorities un

58、dertake monetary policy and of who should be in charge of it. The second group contend that there are other important channels that traditional theories overlook. These channels specifically relate to the important role played by banks within the financial system; see Bernanke and Gertler (1995) and

59、 Dimsdale (2001) for lucid expositions of how these channels work. A particularly important example is in the way firms are financed. For example small and medium sized firms tend to rely exclusively on bank lending whereas larger firn1s are able to utilise the stock market as an alternative source of finance. If, for instance, following an expansionary monetary policy banks are unwilling to lend money then there will be less investment opportunities for small and medium sized firms. Th